Equity valuation in a de-globalising world


Macro Letter – No 68 – 13-01-2017

Equity valuation in a de-globalising world

  • The Federal Reserve will raise rates in the coming year
  • The positive Yield Gap will vanish but equity markets should still rise
  • After an eight year bull market equities are vulnerable to negative shocks
  • A value based investment approach is to be favoured even in the current environment

In this Macro Letter I review stock market valuation. I conclude with some general recommendations but the main purpose of my letter is to investigate different methods of valuation and consider the benefits and dangers of diversification. I begin by looking at the US market and the prospects for the US economy. Then I turn to global equity markets, where I consider the benefits and perils of diversification into Frontier stocks. I go on to review global industry sectors, before returning to examine the long term value to be found in developed markets. I finish by looking at the recent outperformance of Value versus Growth.

US Stocks and the Yield Gap

The Equity bull market is entering its eighth year and for US stocks this is the second longest bull-market since WWII – the longest being, between 1987 and 2000. The current bull-market has differed from the 1987-2000 period in that interest rates have fallen throughout the period. Bond yields have also declined to historically low levels. The Yield Gap – the premium of dividend yields over bond yields – which had been inverted since the mid-1950’s, turned positive once more. The chart below shows the yield of the S&P500 and 10yr T-Bonds since 1900:-


Source: Reuters

What this chart shows most clearly is that the return to a positive Yield Gap has been a function of falling bond yields rather than any substantial rise in dividend pay-out.

The chart below looks at the relationships between the Yield Gap and the real return on US 10yr Treasuries and S&P500 dividends since 1930 – I have used the Implicit Price Deflator as the measure of inflation:-


Source: Multpl, St Louis Federal Reserve

The decline in the real dividend yield was a response to rising inflation from the late 1950’s onwards. The return to a positive Yield Gap has been a recent phenomenon. The average Yield Gap since 1900 is -0.51%, since 1930 it has been -1.17%. It has been below its long-run average at -0.37% since 2008. The executive officers of US corporations will continue to favour share buy-backs over increased dividends – I do not expect dividend yields to keep pace with any pick-up in inflation in the near-term, but, share buy-backs will continue to support stocks in general.

S&P 500 forecasts for 2017

What does this mean for the return on the S&P 500 in 2017? According to Bloomberg, the consensus forecast is for a rise of 4% but the range of forecasts is a rather narrow +1.3% to +8.3%. As at the close on 11th January we were already up 1.6% from the 30th December close.

Corporate earnings continue to rise although the pace of increase has moderated. Factset Earning Insight – January 6th – makes the following observations:-

Earnings Growth: For Q4 2016, the estimated earnings growth rate for the S&P 500 is 3.0%. If the index reports earnings growth for Q4, it will mark the first time the index has seen year-over-year growth in earnings for two consecutive quarters since Q4 2014 and Q1 2015.

Earnings Revisions: On September 30, the estimated earnings growth rate for Q4 2016 was 5.2%. Ten of the eleven sectors have lower growth rates today (compared to September 30) due to downward revisions to earnings estimates, led by the Materials sector.

Earnings Guidance: For Q4 2016, 77 S&P 500 companies have issued negative EPS guidance and 34 S&P 500 companies have issued positive EPS guidance.

Valuation: The forward 12-month P/E ratio for the S&P 500 is 17.1. This P/E ratio is above the 5-year average (15.1) and the 10-year average (14.4).

Earnings Scorecard: As of today (with 4% of the companies in the S&P 500 reporting actual results for Q4 2016), 73% of S&P 500 companies have beat the mean EPS estimate and 36% of S&P 500 companies have beat the mean sales estimate.

…For Q1 2017, analysts are projecting earnings growth of 11.0% and revenue growth of 7.9%.

For Q2 2017, analysts are projecting earnings growth of 10.5% and revenue growth of 6.0%.

For all of 2017, analysts are projecting earnings growth of 11.5% and revenue growth of 5.9%.

…At the sector level, the Energy (33.2) sector has the highest forward 12-month P/E ratio, while the Telecom Services (14.2) and Financials (14.2) sectors have the lowest forward 12-month P/E ratios. Nine sectors have forward 12-month P/E ratios that are above their 10-year averages, led by the Energy (33.2 vs. 17.9) sector. One sector (Telecom Services) has a forward 12-month P/E ratio that is below the 10-year average (14.2 vs. 14.6).

Other indicators, which should be supportive for the US economy, include the ISM – PMI Index which is closely correlated to the business cycle. It came in at 54. 7 the highest since November 2014. Here is a 10 year chart:-


Source: Trading Economics, Institute for Supply Management

A shorter-term indicator for the US economy is the Citigroup Economic Surprise Index – CESI. The chart below suggests that the surprise caused by Trump’s presidential victory is still gathering momentum:-


Source: Yardeni, Citigroup

With both the ISM and the CESI indices rising, even the most bearish of macro-economist is likely to be “sceptically positive” on the US economy and this should be supportive for the US stock market.

Global Stocks

I have focussed on the US stock market because of the close correlation between the US and other major stock markets around the world.

As the world becomes less globalised, or as one moves away from the major stock markets, the diversification benefits of a global portfolio, such as the one Andrew Craig describes in his book “How to Own the World”, becomes more enticing. Andrew recommends diversification by asset class, but even a diversified equity portfolio – without the addition of bonds, commodities, real-estate and infrastructure – can offer an enhanced Sharpe Ratio. The table below looks at the three year monthly correlations of emerging and frontier stock markets with a correlation of less than 0.40 to the US market:-

Country Correlations < 0.40 to US stocks – 36 months
Malawi -0.12
Iraq -0.12
Panama -0.01
Cambodia 0.00
Rwanda 0.01
Venezuela 0.01
Uganda 0.01
Trinidad and Tobago 0.02
Tunisia 0.02
Botswana 0.07
Mauritius 0.07
Tanzania 0.08
Palestine 0.09
Laos 0.09
Ghana 0.10
Zambia 0.10
Peru 0.11
Bahrain 0.13
Jordan 0.15
Cote D’Ivoire 0.15
Sri Lanka 0.16
Argentina 0.17
Nigeria 0.17
Qatar 0.21
Kenya 0.21
Pakistan 0.24
Jamaica 0.24
Oman 0.25
Colombia 0.27
Saudi Arabia 0.31
Kuwait 0.36
China 0.37
Bermuda 0.38
Egypt 0.38
Vietnam 0.39

Source: Investment Frontier

Many of these stock markets are illiquid or suffer from investment restrictions: but here you will find some of the fastest growing economies in the world. These correlations look beguilingly low but remember that during broad-based market declines short-term correlations tend to rise – the illusory nature of liquidity drives this process. The price of a financial asset is driven by investment flows, cognitive behavioural biases drive investment decisions. Herd instinct rises dramatically when fear replaces greed.

Industry Sectors

The major stock markets also offer opportunities. Looking globally by industry sector there are some attractive longer-term value propositions. The table below ranks the major markets by sector as at 30th December 2016. The sectors have been sorted by trailing P/E ratio (mining and alternative energy P/E data is absent but by other measures mining is relatively cheap):-

Industry Sector PE PC PB PS DY
Real Est Serv 11.2 14.9 1 2.2 2.70%
Auto 12.1 5.7 1.4 0.6 2.50%
Banks 13.8 9.6 1.1 3.30%
Life Insur 14.2 6.4 1.1 0.7 3.00%
Electricity 14.9 5.6 1.3 1.1 4.00%
Forest & Paper 15.1 7.1 1.6 0.9 2.90%
Nonlife Ins 16.2 10.4 1.3 1 2.40%
Financial Serv 16.7 13.8 1.8 2.3 2.20%
Telecom (fxd) 17.5 5.5 2.3 1.4 4.20%
Travel & Leisure 17.6 9.1 2.9 1.4 2.10%
Tech HW & Equ 18.3 10.7 3 1.8 2.30%
Chemicals 18.8 10.1 2.4 1.3 2.60%
Household Gds 18.8 15 2.8 1.7 2.40%
Gen Ind 19 11.3 1.9 1.1 2.40%
REITs 20.4 16.7 1.7 7.7 4.50%
Construction 20.9 11.4 1.9 0.9 2.10%
Telecom (mob) 21.4 5.6 1.9 1.5 3.30%
Tobacco 21.5 21.1 9.8 4.9 3.60%
Media 21.6 10.9 2.9 2 2.10%
Food Retail 21.6 10.2 2.8 0.4 2.00%
Eltro & Elect Equ 21.7 12.2 2.2 1 1.70%
Pharma & Bio 22.4 16.3 3.4 3.5 2.30%
Food Prod 23.2 14.3 2.6 1.2 2.20%
Healthcare 23.7 13.1 3.2 1.4 1.10%
Leisure Gds 23.9 8.4 2 1.1 1.20%
Inds Transport 23.9 10.4 2.5 1.3 2.50%
Aero & Def 23.9 14.9 5 1.3 2.10%
Inds Eng 24.6 12.4 2.5 1.1 2.00%
Personal Gds 24.7 16.8 4.3 2 2.00%
Gen Retail 25.8 14 4.2 1 1.70%
Support Serv 26.4 11.9 2.8 1.1 1.90%
Beverages 27 14.9 4.2 2.4 2.70%
SW & Comp Serv 27.3 15.9 4.5 3.8 1.10%
Oil Service 73.9 11.8 1.9 1.7 3.70%
Oil&Gas Prod 116.9 8.2 1.4 1 3.10%
Inds Metal 165.7 7.7 1.1 0.7 2.40%
Mining 8.9 1.6 1.5 1.90%
Alt Energy 10.5 1.7 0.9 1.20%

Source: Star Capital

A number of sectors have been out of favour since 2008 and may remain so in 2017 but it is useful to know where under-performance can be found.

Developed Market Opportunities

At a country level there is better long-term valuation to be found outside the US, even among the developed countries. Here is Star Capital’s 10 to 15 year total annual return forecast for the major markets and regions:-

Country CAPE Forecast PB Forecast ø Forecast
Italy 12.7 9.10% 1.2 10.40% 9.70%
Spain 11.7 9.70% 1.4 8.80% 9.30%
United Kingdom 14.8 8.00% 1.8 7.20% 7.60%
France 18.3 6.60% 1.6 8.10% 7.30%
Australia 16.8 7.10% 2 6.60% 6.90%
Germany 18.6 6.40% 1.8 7.40% 6.90%
Japan 24.9 4.40% 1.3 9.40% 6.90%
Netherlands 19.8 6.00% 1.8 7.20% 6.60%
Canada 20.5 5.70% 1.9 6.90% 6.30%
Sweden 20.6 5.70% 2.1 6.20% 5.90%
Switzerland 21.5 5.40% 2.4 5.30% 5.30%
United States 26.4 4.00% 2.9 4.10% 4.00%
Emerging Markets 14 8.40% 1.6 7.90% 8.20%
Developed Europe 16.6 7.20% 1.8 7.40% 7.30%
World AC 20.8 5.60% 2 6.70% 6.20%
Developed Markets 21.9 5.30% 2 6.50% 5.90%

Source: Star Capital, Bloomberg, Reuters

I have sorted this data based on Star Capital’s composite annual return forecast. The first three countries, Italy, Spain and the UK, all face uncertainty linked to the future of the EU. Interestingly Switzerland offers better long-term returns than the US – with considerably less currency risk for the international investor.

Value Investing

Since the financial crisis in 2008 through to 2015 Growth stocks outperformed Value stocks. I predict a sea-change. The fathers of Value Investing, Ben Graham and David Dodd first published Securities Analysis in 1934. Towards the end of his career Graham opined (emphasis is mine):-

I am no longer an advocate of elaborate techniques of security analysis in order to find superior value opportunities. This was a rewarding activity, say, 40 years ago, when our textbook “Graham and Dodd” was first published; but the situation has changed a great deal since then. In the old days any well-trained security analyst could do a good professional job of selecting undervalued issues through detailed studies; but in the light of the enormous amount of research now being carried on, I doubt whether in most cases such extensive efforts will generate sufficiently superior selections to justify their cost. To that very limited extent, I’m on the side of the “efficient market” school of thought now generally accepted by the professors.

As we embrace the “Big Data” era, the cost of analysing vast amounts of data will collapse, whilst, at the same time, the amount of available data will grow exponentially. I believe we are at the dawn of a new age for Value Investing where the quantitative analysis of a vast array of qualitative factors will allow investors to defy the Efficient Market Hypothesis, even if we cannot satisfactorily refute Eugene Fama’s premise. In 2016, for the first time in seven years, Value beat Growth across all major categories:-


Source: MSCI, Bloomberg

Value stocks tend to exhibit higher volatility than growth stocks, but volatility is only one aspect of risk: buying Value offers long-term protection, especially during an economic downturn. According to Bloomberg’s Nir Kaissar, Value has consistently underperformed Growth since the financial crisis except in US Small Cap’s – his article – Value Investing Hits Back – is insightful.

Conclusion and Investment Opportunities

When I first began investing in stocks the one of the general rules was to buy when the P/E ratio was below 10 and sell when it rose above 20. Today, of the world’s major stock markets, only Russia and China offer single digit P/Es – low ratios are a structural feature of these markets. I wrote about Russia last month in – Russia – Will the Bear come in from the cold? My conclusion was that one should be cautiously optimistic:-

The Russian stock market has already factored in much of the positive economic and political news. The OPEC deal took shape in a series of well publicised stages. The “Trump Effect” is unlikely to be as significant as some commentators hope. The ending of sanctions is the one factor which could act as a positive price shock, however, the Russian economy has suffered a severe recession and now appears to be recovering of its own accord.

Interest rates in the US will rise, though probably not by as much, nor as quickly as the market is currently betting. A value based approach to stock selection offers greater protection and greater return in the long run.

The US stock market continues to rise. The US economy looks set to grow more rapidly in 2017 due to tax cuts and fiscal stimulus, but, for international companies which export to the US, the threat of protectionism is likely to temper enthusiasm for their stocks.

US financial services firms were a big winner after the Trump election result, they should continue to benefit even as interest rates increase – yield curves will steepen, increasing return on capital. US telecommunications stocks have a performed well since the election along with biotechnology – I have no specific view on these industries. Energy stocks have also rallied, perhaps as much on the OPEC deal as the Trump triumph – many new technologies are starting to be implemented by the energy industry but enthusiasm for these stocks may be tempered by a decline in oil prices once the rig count rebounds. The Baker-Hughes Rig Count ended the year at 525 up from a low of 316 in May. The old high of 1,609 was set back in October 2014 – there is plenty of spare capacity which will exert downward pressure on oil prices.

Indian economic growth will outpace China for another year. Despite a weakening Chinese Yuan, Vietnam remains competitive – it is on the cusp of moving from Frontier to Emerging Market status. Indonesia also looks likely to perform well during 2017, GDP forecasts are around 5%; however, Indonesia’s strong reliance on commodity exports makes it more vulnerable than some of its South and East Asian neighbours.

US growth – has the windfall of cheap oil arrived or is there a spectre at the feast?


Macro Letter – No 53 – 22-04-2016

US growth – has the windfall of cheap oil arrived or is there a spectre at the feast?

  • Oil prices have been below $60/bbl since late 2014
  • The benefit of cheaper oil is being felt across the US
  • Without lower oil prices US growth would be significantly lower
  • Increasing levels of debt are stifling the benefits of lower prices

In this letter I want to revisit a topic I last discussed back in June 2015 – Can the boon of cheap energy eclipse the collapse of energy investment? In this article I wrote:-

The impact of the oil price collapse is still feeding through the US economy but, since the most vulnerable states have learnt the lessons of the 1980’s and diversified away from an excessive reliance of on the energy sector, the short-run downturn will be muted whilst the long-run benefits of new technology will be transformative. US oil production at $10/barrel would have sounded ludicrous less than five years ago: today it seems almost plausible.

This week the San Francisco Fed picked up the theme in their FRBSF Economic Letter – The Elusive Boost from Cheap Oil:-

The plunge in oil prices since the middle of 2014 has not translated into a dramatic boost for consumer spending, which has continued to grow moderately. This has been particularly surprising since the sharp drop should free up income for households to use toward other purchases. Lessons from an empirical model of learning suggest that the weak response may reflect that consumers initially viewed cheaper oil as a temporary condition. If oil prices remain low, consumer perceptions could change, which would boost spending.

Given the perceived wisdom of the majority of central banks – that deflation is evil and must be punished – the lack of consumer spending is a perfect example of the validity of the Fed’s inflation targeting policy; except that, as this article suggests, deflations effect on spending is transitory. I could go on to discuss the danger of inflation targeting, arguing that the policy is at odds with millennia of data showing that technology is deflationary, enabling the consumer to pay less and get more. But I’ll save this for another day.

The FRBSF paper looks at the WTI spot and futures price. They suggest that market participants gradually revise their price assumptions in response to new information, concluding:-

The steep decline in oil prices since June 2014 did not translate into a strong boost to consumer spending. While other factors like weak foreign growth and strong dollar appreciation have contributed to this weaker-than-expected response, part of the muted boost from cheaper oil appears to stem from the fact that consumers expected this decline to be temporary. Because of this, households saved rather than spent the gains from lower prices at the pump. However, continued low oil prices could change consumer perceptions, leading them to increase spending as they learn about this greater degree of persistence.

In a related article the Kansas City Fed – Macro Bulletin – The Drag of Energy and Manufacturing on Productivity Growth observes that the changing industry mix away from energy and manufacturing, towards the production of services, has subtracted 0.75% from productivity growth. They attribute this to the strength of the US$ and a decline in manufacturing and mining.

…even if the industry mix stabilizes, the relative rise in services and relative declines in manufacturing and mining are likely to have a persistent negative effect on productivity growth going forward.

The service and finance sector of the economy has a lower economic multiplier than the manufacturing sector, a trend which has been accelerating since 1980. A by-product of the growth in the financial sector has been a massive increase in debt relative to GDP. By some estimates it now requires $3.30 of debt to create $1 of GDP growth. A reduction of $35trln would be needed to get debt to GDP back to 150% – a level considered to be structurally sustainable.

Meanwhile, US corporate profits remain a concern as this chart from PFS group indicates:-


Source: PFS Group, Bloomberg

The chart below from Peter Tenebrarum – Acting Man looks at whole economy profits – it is perhaps more alarming still:-


Source: Acting Man

With energy input costs falling, the beneficiaries should be non-energy corporates or consumers. Yet wholesale inventories are rising, total business sales seem to have lost momentum and, whilst TMS-2 Money Supply growth remains solid at 8%, it is principally due to commercial and industrial lending.

US oil production has fallen below 9mln bpd versus a peak of 9.6mln. Rig count last week was 351 down three from the previous week but down 383 from the same time last year. Meanwhile the failure of Saudi Arabia to curtail production, limits the potential for the oil market to rally.

From a global perspective, cheap fuel appears to be cushioning the US from economic headwinds in other parts of the world. Employment outside mining and manufacturing is steady, and wages are finally starting to rise. However, the overhang of debt and muted level of house price appreciation has dampened the animal spirits of the US consumer:-


Source: Global Property Guide, Federal Housing Finance Agency

According to the Dallas Fed – Increased Credit Availability, Rising Asset Prices Help Boost Consumer Spendingthe consumer is beginning to emerge:-

A combination of much less household debt, revived access to consumer credit and recovering asset prices have bolstered U.S. consumer spending. This trend will likely continue despite an estimated 50 percent reduction since the mid-2000s of the housing wealth effect— an important amplifier during the boom years.

…Since the Great Recession, the ratio of household debt-to-income has fallen back to about 107 percent, a more sustainable—albeit relatively high—level.

…The wealth-to-income ratio rose from about 530 percent in fourth quarter 2003 to 650 percent in mid-2007 as equity and house prices surged. Not surprisingly, consumer spending also jumped.

The conventional estimate of the wealth effect—the impact of higher household wealth on aggregate consumption—is 3 percent, or $3 in additional spending every year for each $100 increase in wealth.

…Recent research suggests that the spendability, or wealth effect, of liquid financial assets—almost $9 for every $100—is far greater than the effect for illiquid financial assets, which explains why falling equity prices do not generate larger cutbacks in aggregate consumer spending. Other things equal, higher mortgage and consumer debt significantly depress consumer spending.

…The estimated housing wealth effect varies over time and captures the ability of consumers to tap into their housing wealth. It rose steadily from about 1.3 percent in the early 1990s to a peak of about 3.5 percent in the mid- 2000s. It has since halved, to about the same level as that of the mid-1990s. During the subprime and housing booms, rising house prices and housing wealth effects propagated and amplified expansion of consumption and GDP.

During the bust, this mechanism went into reverse. High levels of mortgage debt, falling house prices and a reduced ability to tap housing equity generated greater savings and reduced consumer spending. Fortunately, house prices have recovered, deleveraging has slowed or stopped, and consumer spending is strong, even though the housing wealth effect is only half as large as it was in the mid-2000s.

Countering the positive spin placed on the consumer credit data by the Dallas Fed is a recent interview with  Odysseas Papadimitriou, CEO of CardHub by Financial Sense – Credit Card Debt Levels Reaching Unsustainable Levels:-

In 2015, we accumulated almost $71 billion in new credit card debt. And for the first time since the Great Recession, we broke the $900 billion level in total credit card debt so we are back on track in getting to $1 trillion.


Source: Bloomberg, Financial Sense

Another factor which has been holding back the US economy has been the change in the nature of employment. Full-time jobs have been replaced by lower paying part-time roles and the participation rate has been in decline. This may also be changing, but is likely to be limited, as the Kansas City Fed – Flowing into Employment: Implications for the Participation Rate reports:-

After a long stretch of declines, the labor force participation rate has risen in recent months, driven in part by an increase in the share of prime-age people flowing into employment from outside the labor force. So far, this flow has remained largely confined to those with higher educational attainment, suggesting further increases in labor force participation rate could be relatively limited.

…Overall, the scenarios show that while more prime-age people could enter the labor force in the coming years, the cyclical improvement in the overall participation rate may be limited to the extent only those with higher educational attainment flow into employment. In addition, the potential increase in the participation rate could be constrained by other factors such as an increase in the share of prime-age population that reports they are either retired or disabled and a limited pool of people saying they want a job, even if they have not looked recently. Thus, while higher NE flow indicates the prime-age participation rate could increase further, it will likely remain lower than its pre-recession rate.


At the 2015 EIA conference Adrian Cooper of Oxford Economics gave a presentation – The Macroeconomic Impact of Lower Oil Prices – in which he estimated that a $30pb decline in the oil price would add 0.9% to US GDP between 2015 and 2017. If this estimate is correct, lower oil is responsible for more than a quarter of the current US GDP growth. It has softened the decline from 2.9% to 2% seen over the last year.

I would argue that the windfall of lower oil prices has already arrived, it has shown up in the deterioration of the trade balance, the increase in wages versus consumer prices and the nascent rebound in the participation rate. That the impact has not been more dramatic is due to the headwinds on excessive debt and the strength of the US$ TWI – it rose from 103 in September 2014 to a high of 125 in January 2016. After the G20 meeting Shanghai it has retreated to 120.

According to the March 2015 BIS – Oil and debt report, total debt in the Oil and Gas sector increased from $1trln in 2006 to $2.5trln by 2015. The chart below looks at the sectoral breakdown of US Capex up to the end of 2013:-

US CAPEX by sector

Source: Business Insider, Compustat, Goldman Sachs

With 37% allocated to Energy and Materials by 2013 it is likely that the fall in oil prices will act as a drag on a large part of the stock market. Energy and Materials may represent less than 10% of the total but they impact substantially in the financial sector (15.75%).

Notwithstanding the fact that corporate defaults are at the highest level for seven years, financial institutions and their central bank masters will prefer to reschedule. This will act as a drag on new lending and on the profitability of the banking sector.

The table below from McGraw Hill shows the year to date performance of the S&P Spider and the sectoral ETFs. This year Financials are taking the strain whilst Energy has been the top performer – over one year, however, Energy is still the nemesis of the index.

Sector SPDR Fund % Change YTD % Change 1 year
S&P 500 Index 2.86% 0.10%
Consumer Discretionary (XLY) 2.23% 5.05%
Consumer Staples (XLP) 4.16% 6.83%
Energy (XLE) 10.20% -19.16%
Financial Services (XLFS) -2.49% 0.00%
Financials (XLF) -1.22% -2.85%
Health Care (XLV) -1.01% -3.31%
Industrials (XLI) 6.41% -0.07%
Materials (XLB) 8.45% -5.78%
Real Estate (XLRE) 1.98% 0.00%
Technology (XLK) 3.60% 5.19%
Utilities (XLU) 10.74% 7.08%

Source: McGraw Hill

The benefit of lower oil and gas prices will continue, but, until debt levels are reduced, anaemic GDP growth is likely to remain the pattern for the foreseeable future. In Hoisington Investment Management – Economic Review – Q1 2016 – Lacy Hunt makes the following observation:-

The Federal Reserve, the European Central Bank, the Bank of Japan and the People’s Bank of China have been unable to gain traction with their monetary policies…. Excluding off balance sheet liabilities, at year-end the ratio of total public and private debt relative to GDP stood at 350%, 370%, 457% and 615%, for China, the United States, the Eurocurrency zone, and Japan, respectively…

The windfall of cheap oil has arrived, but cheap oil has been eclipsed by the beguiling spectre of cheap debt.

What are the bond markets telling us about inflation, recession and the path of central bank policy?


Macro Letter – No 41 – 11-09-2015

What are the bond markets telling us about inflation, recession and the path of central bank policy?

  • Since January US Government bond yields have risen across the yield curve
  • Corporate bond yields have risen more rapidly as stock markets have retreated
  • China, Canada and Mexico have seen their currencies weaken against the US$

For several years some commentators have been concerned that the Federal Reserve is behind the curve and needs to tighten interest rates before inflation returns. To date, inflation – by which I refer narrowly to CPI – has remained subdued. The recent recovery in the US economy and improvement in the condition of the labour market has seen expectations of rate increases grow and bond market yields have risen in response. In this letter I want to examine whether the rise in yields is in expectation of a Fed rate increase, fears about the return of inflation or the potential onset of a recession for which the Federal Reserve and its acolytes around the globe are ill-equipped to manage.

Below is a table showing the change in yields since the beginning of February. Moody Baa rating is the lowest investment grade bond. Whilst the widening of spreads is consistent with the general increase in T-Bond yields, the yield on Baa bonds has risen by 30bp more than Moody BB – High Yield, sub-investment grade. This could be the beginning of an institutional reallocation of risk away from the corporate sector.

Bond       Spread over T-Bonds    
08-Sep 02-Feb Change 08-Sep 02-Feb Change
10yr US T-Bond 2.19 1.65 0.54 N/A N/A N/A
Baa Corporate 5.28 4.29 0.99 3.09 2.64 0.45
BB Corporate 5.55 4.86 0.69 3.36 3.21 0.15


Source: Ycharts and Investing.com

The chart below shows the evolution of Baa bond yields over the last two years:-

FRED Baa Corporate bond yield 2013-2015

Source: St Louis Federal Reserve

The increase in the cost of financing for the corporate sector is slight but the trend, especially since May, is clear.

Another measure of the state of the economy is the breakeven expected inflation rate. This metric is derived from the differential between 10-Year Treasury Constant Maturity Securities and 10-Year Treasury Inflation-Indexed Constant Maturity Securities:-

FRED Breakeven Inflation rate 2007-2015

Source: St Louis Federal Reserve

By this measure inflation expectations are near their lowest levels since 2010. It looks as if the bond markets are doing the Federal Reserve’s work for it. Added to which the July minutes of the FOMC stated:-

The risks to the forecast for real GDP and inflation were seen as tilted to the downside, reflecting the staff’s assessment that neither monetary nor fiscal policy was well positioned to help the economy withstand substantial adverse shocks.

This is hardly hiking rhetoric.

The International perspective

The table below looks at the largest importers into the US and their contribution to the US trade deficit as at December 2014:-

Country/Region Imports Deficit
China $467bln $343bln
EU $418bln $142bln
Canada $348bln $35bln
Mexico $294bln $54bln
Japan $134bln $68bln

Source: US Census Bureau

The TWI US$ Index shows a rather different picture to the US$ Index chart I posted last month, it has strengthened against its major trading partners steadily since it lows in July 2011; after a brief correction, during the first half of 2015, the trend has been re-established and shows no signs of abating:-

FRED USD TWI 2008-2015

Source: St Louis Federal Reserve

A closer inspection of the performance of the Loonie (CAD) and Peso (MXN) reveals an additional source of disinflation:-

CAD and MXN vs USD 2yr

Source: Yahoo Finance

Focus Economics – After dismal performance in May, exports and imports increase in June – investigates the bifurcated impact of lower oil prices and a weaker currency on the prospects for the Mexican economy:-

Looking at the headline numbers, exports increased 1.2% year-on-year in June, which pushed overseas sales to USD 33.8 billion. The monthly expansion contrasted the dismal 8.8% contraction registered in May. June’s expansion stemmed mainly from a solid increase in non-oil exports (+6.8% yoy). Conversely, oil exports registered another bleak plunge (-41.0% yoy).

Should the U.S. economy continue to recover and the Mexican peso weaken, growth in Mexico’s overseas sales is likely to continue improving in the coming months.

Mexico’s gains have to some extent been at the expense of Canada as this August 2015 article from the Fraser Institute – Canada faces increased competition in U.S. market – explains:-

There are several possible explanations of the cessation of real export growth to the U.S. One is the slow growth of the U.S. economy over much of the period from 2000-2014, particularly during and following the Great Recession of 2008. Slower real growth of U.S. incomes can be expected to reduce the growth of demand for all types of goods including imports from Canada.

A second possible explanation is the appreciation of the Canadian dollar over much of the time period. For example, the Canadian dollar increased from an all-time low value of US$.6179 on Jan. 21, 2002 to an all-time high value of US$1.1030 on Nov. 7, 2007. It then depreciated modestly to a value of US$.9414 by Jan. 1, 2014.

A third possible explanation is the higher costs to shippers (and ultimately to U.S. importers) associated with tighter border security procedures implemented by U.S. authorities after 9/11.

Perhaps a more troubling and longer-lasting explanation is Canada’s loss of U.S. market share to rival exporters. For example, Canada’s share of total U.S. imports of motor vehicles and parts decreased by almost 12 percentage points from 2000 through 2013, while Mexico’s share increased by eight percentage points. Canada lost market share (particularly to China) in electrical machinery and even in its traditionally strong wood and paper products sectors.

There is fundamentally only one robust way for Canadian exporters to reverse the recent trend of market share loss to rivals. Namely, Canadian manufacturers must improve upon their very disappointing productivity performance over the past few decades—both absolutely and relatively to producers in other countries. Labour productivity in Canada grew by only 1.4 per cent annually over the period 1980-2011. By contrast, it grew at a 2.2 per cent annual rate in the U.S. Even worse, multifactor productivity—basically a measure of technological change in an economy—did not grow at all over that period in Canada.

With an election due on 19th October, the Canadian election campaign is focused on the weakness of the domestic economy and measures to stimulate growth. While energy prices struggle to rise, non-energy exports are likely to be a policy priority. After rate cuts in January and July, the Bank of Canada left rates unchanged this week, but with an election looming this is hardly a surprise.

China, as I mentioned in my last post here, unpegged its currency last month. Official economic forecasts remain robust but, as economic consultants Fathom Consulting pointed out in this July article for Thomson Reuters – Alpha Now – China a tale of two economies – there are many signs of a slowing of economic activity, except in the data:-

With its usual efficiency, China’s National Bureau of Statistics released its 2015 Q2 growth estimate earlier this week. Reportedly, GDP rose by 7.0% in the four quarters to Q2. We remain sceptical about the accuracy of China’s GDP data, and the speed with which they are compiled. Our own measure of economic activity — the China Momentum Indicator — suggests the current pace of growth is nearer 3.0%.

…although policymakers are reluctant to admit that China has slowed dramatically, the recent onslaught of measures aimed at stimulating the economy surely hints at their discomfort. While these measures may temporarily alleviate the downward pressure, they do very little to resolve China’s long standing problems of excess capacity, non-performing loans and perennially weak household consumption.

Accordingly, as China tries out the full range of its policy levers, we believe that eventually it will resort to exchange rate depreciation. Its recent heavy-handed intervention in the domestic stock market has demonstrated afresh its disregard for financial reform.

The chart below is the Fathom Consulting – China Momentum Indicator – note the increasing divergence with official GDP data:-


Source: Fathom Consulting/Thomson Reuters

A comparison between international government bonds also provides support for those who argue Fed policy should remain on hold:-

Government Bonds 2yr 2yr Change 5yr 5yr Change 10yr 10yr Change 30yr 30yr Change
08-Sep 02-Feb 08-Sep 02-Feb 08-Sep 02-Feb 08-Sep 02-Feb
US 0.74 0.47 0.27 1.52 1.17 0.35 2.19 1.65 0.54 2.96 2.23 0.73
Canada 0.45 0.39 0.06 0.79 0.61 0.18 1.48 1.25 0.23 2.24 1.83 0.41
Mexico 5.01* 4.13* 0.88 5.29 4.89 0.4 6.15 5.41 0.74 6.81 6.1 0.71
Germany -0.22 -0.19 -0.03 0.05 -0.04 0.09 0.68 0.32 0.36 1.44 0.9 0.54
Japan 0.02 0.04 -0.02 0.07 0.09 -0.02 0.37 0.34 0.03 1.41 1.31 0.1
China 2.59 3.22 -0.63 3.2 3.45 -0.25 3.37 3.53 -0.16 3.88 4.04 -0.16

*Mexico 3yr Bonds

Source: Investing.com

Canada and Mexico have both witnessed rising yields as their currencies declined, whilst Germany (a surrogate for the EU) and Japan have seen a marginal fall in shorter maturities but an increase for maturities of 10 years or more. China, with a still slowing economy and aided by PBoC policy, has lower yields across all maturities. Mexican inflation – the highest of these trading partners – was last recorded at 2.59% whilst core inflation was 2.31%. The 2yr/10yr curve for both Mexico and Canada, at just over 100bps, is flatter than the US at 145bp. The Chinese curve is flatter still.

A final, if somewhat tangential, article which provides evidence of a lack of inflationary pressure comes from this fascinating post by Stephen Duneier of Bija Advisors – Doctoring Deflation – in which he looks at the crisis in healthcare and predicts that computer power will radically reduce costs globally:-

The future of medical diagnosis is about to experience a radical shift. The same pocket sized computer which now holds the power to beat any human being at the game of chess, will soon be used to diagnose medical ailments and prescribe actions to follow, far more cheaply and with a whole lot more accuracy.

Conclusions and investment opportunities

The bond yield curves of America’s main import partners have steepened in train with the US – Canada being an exception – whilst stock markets are unchanged or lower over the same period – February to September. Corporate bond spreads have widened, especially the bottom of the investment grade category. Corporate earnings have exceeded expectations, as they so often do – see this paper by Jim Liew et al of John Hopkins for more on this topic – but by a negligible margin.

The FOMC has already expressed concern about the momentum of GDP growth, commodity prices remain under pressure, China has unpegged and the US$ TWI has reached new highs. This suggests to me, that inflation is not a risk, disinflationary forces are growing – especially driven by the commodity sector. Major central banks are unlikely to tighten but corporate bond yields may rise further.


Remain long US$ especially against resource based currencies, but be careful of current account surplus countries which may see flight to quality flows in the event of “risk off” panic.


At the risk of stating what any “value” investor should always look for, seek out firms with strong cash-flow, low leverage, earnings growth and comfortable dividend cover. In addition, in the current environment, avoid commodity sensitive stocks, especially in oil, coal, iron and steel.


US T-Bonds will benefit from a strengthening US$, if the FOMC delay tightening this will favour shorter maturities. An early FOMC tightening, after initial weakness, will be a catalyst for capital repatriation – US T-Bonds will fare better in this scenario too. Bunds and JGBs are likely to witness similar reactions but, longer term, both their currencies and yields are less attractive.

US Growth and employment – can the boon of cheap energy eclipse the collapse of energy investment?


Macro Letter – No 38 – 19-06-2015

US Growth and employment – can the boon of cheap energy eclipse the collapse of energy investment?

  • Last year’s oil price falls are still feeding through to the wider economy
  • Oil producing states have remained resilient despite the continued lower price of WTI
  • The wider economy has rebounded after the slowdown in Q1
  • Stock earnings growth is regaining upward momentum

At the end of last year I became cautious about the prospects for the US stock market. The principal concern was the effect a sustained decline in the price of oil was likely to have on the prospects for employment and economic growth.

The Texan Experience

Oil rich Texas represents a microcosm of the effect lower energy prices may be having on employment and growth. This article from December 2014 by Mauldin Economics – Oil, Employment, and Growth – neatly sums up my concerns at the end of last year:-

…we need to research in depth as we try to peer into the future and think about how 2015 will unfold. In forecasting US growth, I wrote that we really need to understand the relationships between the boom in energy production on the one hand and employment and overall growth in the US on the other. The old saw that falling oil prices are like a tax cut and are thus a net benefit to the US economy and consumers is not altogether clear to me. I certainly hope the net effect will be positive, but hope is not a realistic basis for a forecast. Let’s go back to two paragraphs I wrote last week:

Texas has been home to 40% of all new jobs created since June 2009. In 2013, the city of Houston had more housing starts than all of California. Much, though not all, of that growth is due directly to oil. Estimates are that 35–40% of total capital expenditure growth is related to energy. But it’s no secret that not only will energy-related capital expenditures not grow next year, they are likely to drop significantly. The news is full of stories about companies slashing their production budgets. This means lower employment, with all of the knock-on effects.

As we will see, energy production has been the main driver of growth in the US economy for the last five years. But changing demographics suggest that we might not need the job-creation machine of energy production as much in the future to ensure overall employment growth.

…The oil-rig count is already dropping, and it will continue to drop as long as oil stays below $60. That said, however, there is the real possibility that oil production in the United States will actually rise in 2015 because of projects already in the works. If you have already spent (or committed to spend) 30 or 40% of the cost of a well, you’re probably going to go ahead and finish that well. There’s enough work in the pipeline (pardon the pun) that drilling and production are not going to fall off a cliff next quarter. But by the close of 2015 we will see a significant reduction in drilling.

Given present supply and demand characteristics, oil in the $40 range is entirely plausible. It may not stay down there for all that long (in the grand scheme of things), but it will reduce the likelihood that loans of the nature and size that were extended the last few years will be made in the future. Which is entirely the purpose of the Saudis’ refusing to reduce their own production. A side benefit to them (and the rest of the world) is that they also hurt Russia and Iran.

Employment associated with energy production is going to fall over the course of next year. It’s not all bad news, though. Employment that benefits from lower energy prices is likely to remain stable or even rise. Think chemical companies that use natural gas as an input as an example.

I am, however, at a loss to think of what could replace the jobs and GDP growth that the energy complex has recently created. Certainly, reduced production is going to impact capital expenditures. This all leads one to begin thinking about a much softer economy in the US in 2015.

Last month’s employment report suggests we may have avoided the downturn from cheaper oil, but uncertainty remains. Earlier this month the Dallas Fed – Robust Regional Banking Sector Faces New Economic Hurdles whilst focusing on the health of the banking sector, worried that the effect of lower oil prices, combined with higher interest rates, may yet wreak havoc in the Eleventh District. Here are some of the highlights:-

Not only have district banks achieved greater profitability than their counterparts nationwide, but their loan portfolios also have grown twice as fast. District banks returned to lending sooner than banks in the rest of the country and experienced more rapid loan growth due to the region’s economic strength.

…Possibly reflecting banks’ quest for yield in a low-interest-rate environment, the so-called three-year asset/ liability gap has been growing, particularly for district banks. This measure subtracts liabilities with maturities greater than three years (certificates of deposit, for example) from loans and securities with maturities greater than three years and divides the difference by total assets. A bigger gap means that banks would be hurt by rising interest rates because their assets are tied up for a longer time relative to their liabilities. Consequently, when interest rates rise, banks’ funding costs could rise while interest income remains stagnant, squeezing profitability.

…The other big concern is potential fallout from recent dramatic oil and gas price declines, which affects Texas banks in particular. In July 2014, the West Texas Intermediate (WTI) spot price exceeded $105 a barrel; by March, it had tumbled to below $50 before bouncing back to near $60 at the start of May. The size and rapidity of the decline raised concerns about the impact on the Texas economy and Texas banks, especially given the experiences of the energy and financial collapses of the 1980s. While the state’s economy has become more diverse and thus less reliant on the oil and gas industry, the price drop has still negatively affected the Texas economy and labor market. Some pockets of the state remain heavily dependent on the energy sector, making local industries vulnerable to spillover effects. And because of community banks’ close ties to the areas they serve, they are more exposed than large banks.

…One measure of potential distress is the so-called Texas ratio, the book value of an institution’s nonperforming assets as a percent of its tangible equity capital and its loan-loss reserves. Essentially, the Texas ratio compares an institution’s bad assets to its available capital. A Texas ratio above 1 (expressed as 100 percent) indicates that probable and potential losses exceed an institution’s immediate loss-absorbing cushion, putting it at greater risk of bankruptcy. There have been two instances of dramatic oil price declines since 1980; one gives rise to concern and the other to hope.

Between June 1980 and September 1986, the WTI price declined 74 percent in real (inflation-adjusted) terms. Roughly 20 percent of all Texas institutions had a Texas ratio greater than 100 percent by year-end 1988. A staggering 706 Texas banks and thrifts failed—including nine of the 10 largest banking institutions—between September 1986 and year-end 1990.9

A more recent oil price decline, in the second half of 2008 and early 2009, was also dramatic, but in a different way. Over a nine-month period beginning in June 2008, the price fell more than 71 percent. Yet less than 1 percent of Texas banks had a Texas ratio exceeding 100 percent and only seven failed in 2008–09. The slight pickup in bank troubles in 2010 is likely attributable to generally difficult financial and economic conditions that year.

From June 2014 through March 2015, the price of WTI fell 58 percent. Nevertheless, not one Texas bank had a Texas ratio greater than 100 percent as of the first quarter and only one bank had failed as of March.

The bottom line: The persistence of low oil prices seems to matter more for banks than the magnitude of falling prices. A precipitous, but short-lived, decline is likely to have only a minor impact on the banking industry. Even a longer-term decline similar to that seen in the 1980s is unlikely to provoke the same scope of disruption now as it did then.

…Mitigating factors also make Texas banks better able to weather falling oil prices. Memories of the 1980s crisis linger, and the 2008–09 financial crisis is also fresh in the minds of bankers and regulators. Apart from regulatory changes, Texas bankers manage their risks more prudently, using better risk diversification. The Shared National Credit (SNC) program is one example. Generally, large loans are held by multiple institutions through the SNC program, allowing individual institutions to spread the risk of large credit exposures. While the SNC program has been around since 1977, it has grown in importance and coverage. SNC industry trends by sector show that commodities credits, including those tied to the oil and gas industry, increased from $395 billion in 2002 to $798 billion in 2014. Regulatory filings and investor conference calls suggest that energy exposure at the larger banks in Texas is now predominantly through these shared credits.

…The low-interest-rate environment and a flat yield curve with relatively little difference in interest rates across various maturities have pressured bank earnings over the past five years. Banks have responded by extending their maturity profile in an attempt to generate more robust returns. As interest rates normalize, regulators will need to monitor banks’ ability to restructure their maturity profiles and adapt to the new environment.

The impact of recent oil price declines on banks also bears watching, particularly in Texas. While banks appear to be managing their energy exposure well—and a relatively short spell of low energy prices is not expected to have a severe, adverse effect on local banks—the importance of energy in certain regions points to the possibility of relatively large localized disruptions. The banking system has navigated a post crisis path to recovery. Conditions have improved markedly, but the industry must remain vigilant to potential risks to its financial health and stability.

According to the Dallas Fed – Texas Economic Indicatorspublished on 4th June, the region is showing mixed performance:-

Region Employment Growth
Austin 7.70%
Dallas 2.20%
El Paso 3.30%
Houston 0%
San Antonio -0.50%
Southern New Mexico -0.90%

Source: Dallas Federal Reserve

For the state as a whole, April employment was 1% higher versus the US +1.9%. The largest fall was seen in Oil and Gas Extraction (-14.4%) followed by Manufacturing (-4%) and Construction (-2.6%). Leisure and Hospitality led employment increases (5.3%) Information (4.6%) Education and Health (2.6%) and Trade, Transportation and Utilities (2.3%).

The importance of Oil and Gas to Texas, from an employment perspective, is small– only 2.5% of the workforce – but the sector’s impact on the rest of the region’s economy is much greater. Many ancillary sectors, including manufacturing, banking and finance rely on energy. The most encouraging aspect of the data above is the 2.3% increase in Trades, Transportation and Utilities. As an employer this sector amounts to 20.2% of the total. For this sector, lower energy prices are like the tax cut John Mauldin alluded back in December.

The Energy Complex and US growth

The recent energy technology boom has increased the oil and gas sector’s importance – please revisit Manhattan Institute – New Technology for Old Fuels – my personal favourite essay on this subject. The share of oil and gas in total employment peaked in the early 1980s at 0.8% it’s now back to 0.5%. Its share of GDP followed a similar path, falling from 4% in the 1980’s to less than 1% at the start of the millennium; it’s now back around 2%. Energy self-sufficiency remains elusive – the US is still a net oil importer and therefore benefits from lower oil prices. The Energy Information Administration (EIA) estimates a $700 per household saving from the decline in gasoline prices in 2015. This should also spur an increase in capital investment. The traditional estimate of a halving of output has increased dramatically; meanwhile energy efficiency has significantly improved. The fall from $105 to $60 – assuming the market remains around the current level – will probably add 0.4% to GDP.

As one might expect, the direct impact of cheaper oil on the energy sector has been negative. The US rig count fell by 850 between December 2014 and March 2015. Many energy exploration firms have reduced headcount and cut capital expenditure. I don’t believe the benefits of technology have been exhausted by the energy exploration firms, especially the shale-industry. The Manhattan Institute – Shale 2.0 – takes up the story and go on to make some policy recommendations:-

John Shaw, chair of Harvard’s Earth and Planetary Sciences Department, recently observed: “It’s fair to say we’re not at the end of this [shale] era, we’re at the very beginning.” He is precisely correct. In recent years, the technology deployed in America’s shale fields has advanced more rapidly than in any other segment of the energy industry. Shale 2.0 promises to ultimately yield break-even costs of $5–$20 per barrel—in the same range as Saudi Arabia’s vaunted low-cost fields.

The shale industry is unlike any other conventional hydrocarbon or alternative energy sector, in that it shares a growth trajectory far more similar to that of Silicon Valley’s tech firms. In less than a decade, U.S. shale oil revenues have soared, from nearly zero to more than $70 billion annually (even after accounting for the recent price plunge). Such growth is 600 percent greater than that experienced by America’s heavily subsidized solar industry over the same period.

Shale’s spectacular rise is also generating massive quantities of data: the $600 billion in U.S. shale infrastructure investments and the nearly 2,000 million well-feet drilled have produced hundreds of petabytes of relevant data. This vast, diverse shale data domain—comparable in scale with the global digital health care data domain—remains largely untapped and is ripe to be mined by emerging big-data analytics.

Shale 2.0 will thus be data-driven. It will be centered in the United States. And it will be one in which entrepreneurs, especially those skilled in analytics, will create vast wealth and further disrupt oil geopolitics. The transition to Shale 2.0 will take the following steps: 1.Oil from Shale 1.0 will be sold from the oversupply currently filling up storage tanks. 2. More oil will be unleashed from the surplus of shale wells already drilled but not in production. 3. Companies will “high-grade” shale assets, replacing older techniques with the newest, most productive technologies in the richest parts of the fields. 4. And as the shale industry begins to embrace big-data analytics, Shale 2.0 begins.

Further, if the U.S. is to fully reap the economic and geopolitical benefits of Shale 2.0, Congress and the administration should: 1. Remove the old, no longer relevant, rules prohibiting American companies from selling crude oil overseas. 2. Remove constraints, established by the 1920 Merchant Marine Act, on transporting domestic hydrocarbons by ship. 3. Avoid inflicting further regulatory hurdles on an already heavily regulated industry. 4. Open up and accelerate access to exploration and production on federally controlled lands.

Nonetheless, in the near-term, states which benefitted from $100+ crude oil and the energy related innovations it spawned, are now feeling the effects of what appears to be a sustained period of lower energy prices. The EIA predicts WTI crude will average $60 over the course of 2015.

The CFR – Energy Brief – October 2013 – predicted that a 50% oil price fall would affect the employment prospects of eight states in particular:-

State Fall in Employment
Alaska -1.70%
Louisiana -1.60%
North Dakota -2%
New Mexico -0.70%
Oklahoma -2.30%
Texas -1.20%
West Virginia -0.70%
Wyoming -4.30%

Source: Council for Foreign Relations

So far, if Texas is any guide, the negative effects of the oil price decline have failed to materialise.

The effect of a 25% rise in crude oil prices is also worth considering:-

State Employment Change State Employment Change
Wisconsin -0.74 Ohio -0.61
Minnesota -0.73 Missouri -0.6
Tennessee -0.72 Illinois -0.59
Rhode Island -0.71 Massachusetts -0.59
Florida -0.71 Delaware -0.58
New Hampshire -0.7 South Dakota -0.57
Idaho -0.69 New York -0.57
Nevada -0.69 California -0.56
Arizona -0.68 Alabama -0.56
Indiana -0.68 DC -0.5
Nebraska -0.67 Kentucky -0.48
Vermont -0.66 Pennsylvania -0.47
Iowa -0.66 Utah -0.38
New Jersey -0.65 Kansas -0.35
Washington -0.64 Mississippi -0.35
Maryland -0.64 Arkansas -0.34
Georgia -0.64 Montana -0.31
Michigan -0.64 Colorado -0.15
Virginia -0.64 New Mexico 0.36
South Carolina -0.64 West Virginia 0.36
Oregon -0.64 Texas 0.6
Connecticut -0.63 Louisiana 0.78
Maine -0.62 Alaska 0.87
North Carolina -0.62 North Dakota 1.01
Hawaii -0.61 Oklahoma 1.16
Wyoming 2.14

Sources: CFR, U.S. Bureau of Labor Statistics and the Wall Street Journal

The effect on the US as a whole is estimated at -0.43%. In other words, a fall in crude oil is good for employment and should also act as a cathartic stimulus to GDP growth.

A final measure of the vulnerability of the US economy to the recent oil price decline is shown by the next table. This shows the substantial diversification away from the energy sector seen in every one of the major oil producing states since the 1980’s:-

Share of Oil and Gas Extraction as a % of GDP
1981 2000 2010
Alaska 49.5 15.1 19.1
Louisiana 35.5 11.1 9.7
New Mexico 26.1 5.2 5.1
North Dakota 20.3 0.9 4.3
Oklahoma 21.6 4.8 9.1
Texas 19.1 5.8 7.8
West Virginia 2.4 1 1.5
Wyoming 37.1 9.8 18.5

Source: CFR, U.S. Bureau of Economic Analysis

Looking at how unemployment has changed across the 51 states over the last 12 months:-

State April April 12-month net change
2014 2015
Alabama 7.1 5.8 -1.3
Alaska 6.9 6.7 -0.2
Arizona 6.9 6 -0.9
Arkansas 6.3 5.7 -0.6
California 7.8 6.3 -1.5
Colorado 5.4 4.2 -1.2
Connecticut 6.8 6.3 -0.5
Delaware 5.9 4.5 -1.4
DC 7.8 7.5 -0.3
Florida 6.4 5.6 -0.8
Georgia 7.3 6.3 -1
Hawaii 4.5 4.1 -0.4
Idaho 4.9 3.8 -1.1
Illinois 7.4 6 -1.4
Indiana 6 5.4 -0.6
Iowa 4.4 3.8 -0.6
Kansas 4.5 4.3 -0.2
Kentucky 7 5 -2
Louisiana 5.7 6.6 0.9
Maine 5.8 4.7 -1.1
Maryland 5.9 5.3 -0.6
Massachusetts 5.8 4.7 -1.1
Michigan 7.5 5.4 -2.1
Minnesota 4.2 3.7 -0.5
Mississippi 7.8 6.6 -1.2
Missouri 6.3 5.7 -0.6
Montana 4.7 4 -0.7
Nebraska 3.4 2.5 -0.9
Nevada 8.1 7.1 -1
New Hampshire 4.5 3.8 -0.7
New Jersey 6.7 6.5 -0.2
New Mexico 6.7 6.2 -0.5
New York 6.5 5.7 -0.8
North Carolina 6.4 5.5 -0.9
North Dakota 2.7 3.1 0.4
Ohio 5.9 5.2 -0.7
Oklahoma 4.7 4.1 -0.6
Oregon 7 5.2 -1.8
Pennsylvania 6 5.3 -0.7
Rhode Island 8.1 6.1 -2
South Carolina 6.1 6.7 0.6
South Dakota 3.4 3.6 0.2
Tennessee 6.5 6 -0.5
Texas 5.2 4.2 -1
Utah 3.8 3.4 -0.4
Vermont 4 3.6 -0.4
Virginia 5.3 4.8 -0.5
Washington 6.2 5.5 -0.7
West Virginia 6.8 7 0.2
Wisconsin 5.5 4.4 -1.1
Wyoming 4.3 4.1 -0.2

Source: Bureau of Labor Statistics

Only Louisiana (+0.9%) North Dakota (+0.4%) and West Virginia (+0.2%) of the top oil producing states, have witnessed increased levels of unemployment. South Dakota (+0.2%) and South Carolina (+0.6%) were the only other states in the union to see unemployment rise. This is not the picture of a faltering economy.

The Federal Reserve Leading Index, whilst it hit a low point of +0.9% in January – down from +2% in July 2014 – has rebounded – April +1.12% – and has remained in positive territory since August 2009. The Conference Board Leading Economic Index increased 0.7% in April to 122.3, following a +0.4% in March, and a -0.2% February. The Conference Board commented:-

April’s sharp increase in the LEI seems to have helped stabilize its slowing trend, suggesting the paltry economic growth in the first quarter may be temporary. However, the growth of the LEI does not support a significant strengthening in the economic outlook at this time. The improvement in building permits helped to drive the index up this month, but gains in other components, in particular the financial indicators, have been somewhat more muted.

The outlook appears steady rather than robust but this has been the pattern of the economic recovery ever since the first round of quantitative easing (QE) in November 2008.

Conclusion and Equity Investment Opportunities

The US economic recovery remains intact. The long run economic benefits of structurally lower energy prices and energy security are slowly feeding through to the wider economy. This is good for the US and, as long as the US continues to run a trade deficit with the rest of the world, it’s good for the US main trading partners too.

After a sharp correction in October 2014 the S&P500 recovered. Since its January lows the market has ground slowly higher:-

S&P500 - 1yr

Source: Barchart.com

The table below shows a series of additional valuation measures:-

Indicator Ratio Date Start of Data
Trailing 12 month P/E 20.53
Mean 15.54
Min 5.31 Dec 1917
Max 123.73 May 2009 1875
Shiller Case P/E 27.1
Mean 16.61
Min 4.78 Dec 1920
Max 44.19 Dec 1999 1885
Price to Sales 1.81
Mean 1.4
Min 0.8 Mar 2009
Max 1.81 Jun 2015 2001
Price to Book 2.89
Mean 2.75
Min 1.78 Mar 2009
Max 5.06 Mar 2000 2000

Source: multpl.com

On most of these metrics the market looks relatively expensive but the current level of interest rates is unprecedented. JP Morgan Asset Management predict average corporate earnings to grow by 4% in 2015 – stripping out energy stocks this rises to 11%. They also remind investors that the S&P has seen 10 bear markets since 1926. Eight occurred as a result of economic recessions or commodity price shocks (price increases not decreases) and extreme valuations were a contributing factor only on four occasions. They go on to refute the idea that interest rate increases by the Federal Reserve will derail the bull market, pointing to the positive correlation between rising interest rates and rising equity prices when interest rates start from a low point. They make the caveat that the initial reaction to interest rate increases is negative but in the longer term stocks tend to rise.

At the risk of uttering that most dangerous of phrases – “this time it’s different” – I believe the majority of the rise in equity prices was a function of the reduction in the level of interest rates since 2008. This had two effects; investors switched from interest bearing securities to equities, hoping that capital appreciation would offset the declining income from bonds: and corporations, faced with negative real interest rates, decided to raise dividends and buy back stock, rather than make capital investments when interest rates were artificially low. The chart below shows US 10yr Government Bond yields since 1790:-

US 10 yr Bond Yield Global Financial Data

Source: Global Financial Data

The chart ends in 2013, since when yields have plumbed new depths. Ignoring the inflation shock of the 1970’s and 1980’s it would be reasonable to expect US Treasuries to yield around 3% but that was before the Federal Reserve moved from a stable price target – i.e. around zero – to a 2% inflation target. I think it is reasonable for corporates to assume a long-term cost of finance based on a 3% real yield for US Treasuries plus an appropriate credit spread. Is it any wonder that corporates continue to buy back stock?

The impact of the oil price collapse is still feeding through the US economy but, since the most vulnerable states have learnt the lessons of the 1980’s and diversified away from an excessive reliance of on the energy sector, the short-run downturn will be muted whilst the long-run benefits of new technology will be transformative. US oil production at $10/barrel would have sounded ludicrous less than five years ago: today it seems almost plausible.

US stocks are not cheap, but Q1 earnings declines have been reversed and, whilst growth is muted, the longer term benefits of lower energy prices are just beginning to feed through. At the beginning of the year I was cautious and considering reducing exposure to the US market. Now, I am still cautious, but, if earnings start to improve, today’s valuations will prove justified and further upside may be well ensue. The US bond market is doing the Fed’s work for it – 10yr yields have risen from a low of 1.64% in January to 2.30% today. Whilst the first rise in official rates is likely to act as a negative for stocks, the market will recover as long as the momentum of earnings growth remains positive and energy prices remain subdued.

How the collapse in energy prices will affect US Growth and Inflation and what that means for stocks


Macro Letter – No 26 – 19-12-2014

How the collapse in energy prices will affect US Growth and Inflation and what that means for stocks

  • Oil prices have fallen by more than 40% in H2 2014
  • Inflation expectations will be lowered further
  • US Growth should be higher longer-term
  • Near-term, contagion from the “energy bust” is under estimated by the market


With the recent collapse in the price of crude oil it seems appropriate to review the forecasts for inflation and growth in the US. Earlier this week, during an interview with CNBC, Bill Gross – ex-CIO of PIMCO – suggested that US growth would be around 2% going forward rather than the 3% to 4% seen in the recent past. The Atlanta Fed – Now GDP forecast for Q4 2014 was revised up to +2.2% from +2.1% on 11th December. This is higher than the Conference Board – Q4 GDP forecast of 2.0% from 10th December, here is their commentary:-

The U.S. growth momentum may pause in the fourth quarter, due to some special circumstances. The outlook for early 2015 shows some upside beyond the 2.5 percent pace. And this is despite continued slow economic growth around the world and a rise in the value of the dollar. The biggest disappointment right now is business spending on equipment which is slowing from an average pace of 11 percent over the past two quarters. But if final demand picks up as expected, business investment might also gain some momentum. One key driver of demand is continued improvement in the labor market. Job growth has been solid for the past year and the signal from the latest reading on The Conference Board Employment Trends Index™ (ETI) is that it will continue at least over the very near term. In fact, continued employment gains are likely to lead to better gains in wages in the first half of 2015. Job and income growth may provide some moderately positive momentum for the housing market. Low gasoline prices will also further support household spending. Finally, very low interest rates, at both the short and long end of the yield spectrum help consumers and businesses. The strengthening of domestic growth is intensifying pressures to increase the base interest rate, but speed and trajectory remain important questions.

There is a brief mention of the fall in gasoline prices and hopes for increased domestic demand driven by a better quality of jobs. Thus far official expectations have failed to shift significantly in response to the fall in oil. If the price remains depressed I expect these forecasts to change. The geographic make-up of US growth is quite skewed. The map below shows the breakdown of GDP growth by state in 2013:-

US GDP by State 2013

Source: Bureau of Economic Analysis

The predominant feature of many high growth states is strength of their energy sector. One state which has been a major engine of US employment growth in absolute terms, since the Great Recession, is Texas. In 2013 Texas jobs growth slowed from 3.3% to 2.5%. In percentage terms, it slipped into third place behind the stellar growth seen in North Dakota and Florida. Florida is an interesting indication of the process by which the drivers of growth are gradually switching away from the energy related impetus seen over the past few years. This article from the Dallas Fed – Texas to Remain a Top State for Job Growth in 2014 looks more closely at some nascent growth trends:-

Oil- and gas-producing states—leaders in the early years of the U.S. recovery—no longer predominated. This reflects the energy sector’s slowing expansion, although two states with the strongest shale activity, Texas and North Dakota, remained near the top. Meanwhile, several Sunbelt states hit hard by the housing crisis—Florida, Georgia and Arizona, for instance—are beginning to bounce back. In these states, employment remains significantly below the prerecession peak; in Texas, it is significantly above.

Texas is vulnerable, as are other energy rich US states, due to the weakness in the price of oil, however, Texas is also reliant on trade with Mexico for more than half of its exports. The down-turn in Mexican growth due to the weaker oil price, is an additional headwind for the “lone star” state.

You might expect this to be cause for some relief on the part of Richard Fisher – President of the Dallas Fed, yet, writing in mid-October in the Dallas Fed – Economic Letter – he remained, consistently hawkish on the prospects for inflation:-

The point is not that wage growth has been worrisomely high (it hasn’t been) or that we’re in imminent danger of a wage-price spiral (we likely aren’t). Rather, there’s nothing in the behavior of wage inflation over the course of the recovery to suggest that the unemploy­ment rate has been sending misleading signals about our progress toward full employment. A secondary point—a cau­tion, really—is that when trying to draw inferences about labor-market slack from the behavior of wages, it’s important to recognize that wage inflation’s response to slack is both nonlinear and delayed.

…Do we keep the accelerator pedal to the floor right up to the point where we reach our destination? Or do we ease up as we near our goal? The answer depends on an assessment of the costs of possibly delaying achievement of our objectives versus the costs of overshoot­ing those objectives. Proponents of a patient approach to removing accom­modation emphasize the risk of having to backtrack on policy, should either real growth or inflation expectations falter. On the other hand, Fed policymakers successfully “tapped the brakes” in the middle of three of our longest economic expansions (in the 1960s, 1980s and 1990s), slowing—but not ending—the unemployment rate’s decline. By com­parison, there are no instances where the Fed has successfully eased the unem­ployment rate upward after having first overshot full employment: When the economy goes into reverse, it has a pro­nounced tendency to lurch backward all the way into recession.

The Federal Reserve Bank of San Francisco – The Risks to the Inflation Outlook – November 17th – has a rather different view of the risks of inflation:-

Although inflation is currently low, some commentators fear that continued highly accommodative monetary policy may lead to a surge in inflation. However, projections that account for the different policy tools used by the Federal Reserve suggest that inflation will remain low in the near future. Moreover, the relative odds of low inflation outweigh those of high inflation, which is the opposite of historical projections. An important factor continuing to hold down inflation is the persistent effects of the financial crisis.

The chart below shows the wide range of PCE forecasts, interestingly the IMF WEO forecast is 1.8% for 2015:-

PCE Inflation projection - FRBSF

Source: FRBSF

The author goes on to conclude:-

Overall, this Letter suggests that inflation is not expected to surge in the near future. According to this model, the risks to the inflation outlook remain tilted to the downside. The financial crisis disrupted the credit market, leading to lower investment and underutilization of resources in the economy, causing slower growth, which in turn put downward pressure on inflation. My analysis suggests that these effects from the crisis explain a substantial part of the outlook for inflation. Monetary policy has played a stabilizing role in the recent past, preventing inflation from falling further below its 2% target. Moreover, the analysis suggests that monetary policy is not contributing to the risk of inflation being above the median projection in the near future.

The risk of high inflation in the next one to two years remains very low by historical standards. The analysis suggests that the factors keeping inflation low are expected to be transitory. However, differences between projected and realized inflation in the recent past suggest that those factors may in reality be more persistent than implied by the model.

It would appear that even before the recent decline in the price of oil the Fed was not expecting a significant increase in inflationary pressure. What should they do in the current environment where the US$ continues to appreciate against its major trading partners and if the price of oil remains at or below $60/barrel? These are one-off external price shocks which are a boon to the consumer, however they make exports uncompetitive and undermine the longer term attractiveness of investment in the domestic energy sector. IHS Global Insight produced the following forecast for the Wall Street Journal earlier this month:-


Source: IHS Global Insight and WSJ

My concerns are two-fold; firstly, what if the oil price rebounds? The latest IEA report noted that global demand for oil increased 0.75% between 2013 and 2014 and is running 3.6% above the average level of the last five years (2009 – 2013) this leaves additional supply as the main culprit of the oil price decline. With oil at $60/barrel it is becoming uneconomic to extract oil from many of the new concessions – over-supply may swiftly be reversed. Secondly, the unbridled boon to the wider economy of a lower oil price is likely to be deferred by the process of rebalancing the economy away from an excessive reliance on the energy sector. In an excellent paper in their Power and Growth Initiative series, the Manhattan Institute – Where The Jobs Are: Small Businesses Unleash Energy Employment Boom– February 2014 conclude:-

According to a recent poll from the Washington Post Miller Center, American workers’ anxiety over jobs is at a four-decade record high. Meanwhile, the hydrocarbon sector’s contributions to America’s job picture and the role of its small businesses in keeping the nation out of a long recession are not widely recognized. Another recent survey found that only 16 percent of people know that an oil & gas boom has increased U.S. energy production—collaterally creating jobs both directly and indirectly.

America’s future, of course, is not exclusively associated with hydrocarbons or energy in general. Over the long term, innovation and new technologies across all sectors of the economy will revitalize the nation and create a new cycle of job growth, almost certainly in unexpected ways. But the depth and magnitude of job destruction from the Great Recession means that creating jobs in the near-term is vital. As former chair of the Council of Economic Advisers and Harvard professor Martin Feldstein recently wrote: “The United States certainly needs a new strategy to increase economic growth and employment. The U.S. growth rate has fallen to less than 2%, and total employment is a smaller share of the population now than it was five years ago.”

In a new report evaluating five “game changers” for growth, the McKinsey Global Institute concluded that the hydrocarbon sector has the greatest potential for increasing the U.S. GDP and adding jobs—with an impact twice as great as big data by 2020. McKinsey forecasts that the expanding shale production can add nearly $700 billion to the GDP and almost 2 million jobs over the next six years.

Other analysts looking out over 15 years see 3–4 million more jobs that could come from accelerating domestic hydrocarbon energy production. Even these forecasts underestimate what would be possible in a political environment that embraced growth-centric policies.

In November 2013, President Obama delivered a speech in Ohio on jobs and the benefits from greater domestic energy production. The president highlighted the role of improved energy efficiency and alternative fuels. But as the facts show, no part of the U.S. economy has had as dramatic an impact on short-term job creation as the small businesses at the core of the American oil & gas boom. And much more can be done.

A recent report by Deutsche Bank – Sinking Oil May Push Energy Sector to the Brink – estimated that of $2.8trln annual US private investment, $1.6trln is spent on equipment and software and $700bln on non-residential construction. Of the equipment and software sector, 25-30% is investment in industrial equipment for energy, utilities and agriculture. Non-residential construction is 30% energy related. With oil below $60/barrel much of that private investment will be postponed or cancelled. That could amount to a reduction in private investment of $500bln in 2015. This process is already underway; according to Reuters, new oil permits plummeted 40% in November.

Since 2007 shale producing states have added 1.36mln jobs whilst the non-shale states have shed 424,000 jobs. The table below shows the scale of employment within the energy sector for key states:-

State Hydro-carbon jobs 000’s
Texas 1800
California 780
Oklahoma 350
Louisiana 340
Pennsylvania 330
New York 300
Illinois 290
Florida 280
Ohio 260
Colorado 210
Virginia 190
Michigan 180
Kentucky 170
West Virginia 170
Georgia 160
New Jersey 150

Source: Manhattan Institute

This chart from Zero Hedge shows the evolution of the US jobs market in shale vs non-shale terms since 2008:-

Jobs in shale ve non-shale - Zero Hedge BLS

Source: Zero Hedge and BLS

2015 will see a correction in this trend, not just because investment stalls, but also as a result of defaults in the high-yield bond market.

Junk Bonds and Bank Loans

It is estimated that around 17% of the High-yield bond market in the US is energy related.  The chart below is from Zero Hedge, it shows the evolution of high yield bonds over the last four years. The OAS is the option adjusted spread between High Yield Energy bonds and US Treasury bonds:-


Source: Zero Hedge and Bloomberg

Deutsche Bank strategists Oleg Melentyev and Daniel Sorid estimate that, with oil at $60/barrel, the default rate on B and CCC rated bonds could be as high as 30%. Whilst this is bad news for investors it is also bad news for banks which have thrived on the securitisation of these bonds. The yield expansion seen in the chart above suggests there is a liquidity short-fall at work here – perhaps the Fed will intervene.

As a result of the growth in the US energy sector, banks have become more actively involved in the energy markets. Here the scale of their derivative exposure may become a systemic risk to the financial sector. When oil was trading at its recent highs back in July the total open speculative futures contracts stood at 4mln: that is four times the number seen back in 2010. The banks will also be exposed to the derivatives market as a result of the loans they have made to commodity trading companies – some of whom may struggle to meet margin calls. Bad loan provisions will reduce the credit available to the rest of the economy. This will dampen growth prospects even as lower energy prices help the consumer.

The US Treasury Bond yield curve has also “twisted” over the past month, with maturities of five years and beyond falling but shorter maturities moving slightly higher:-

Maturity 17-Nov 17-Dec Change
2yr 0.504 0.565 0.061
3yr 0.952 1.005 0.053
5yr 1.607 1.534 -0.073
7yr 2.019 1.863 -0.156
10yr 2.317 2.078 -0.239

Source: Investing.com

On the 15th October, at the depths of the stock market correction, 2yr Notes yielded 0.308% whilst 10yr Notes yielded 2.07%. Since then the 2yr/10yr curve has flattened by 25bp. I believe this price move, in the short end of the market, is being driven by expectations that the Fed will move to “normalise” policy rates in the next 12 months. Governor Yellen’s change of emphasis in this weeks FOMC statement – from “considerable time” to “patient” – has been perceived by market pundits as evidence of more imminent rate increases. An additional factor driving short term interest rates higher is the tightening of credit conditions connected to the falling oil price.

Longer maturity Treasuries, meanwhile, are witnessing a slight “flight to quality” as fixed income portfolio managers switch out of High Yield into US government securities even at slightly negative real yields. According to an article in the Financial Times – Fall in oil price threatens high-yield bonds – 7th December $40bln was withdrawn from US High Yield mutual fund market between May and October. I expect this process to gather pace and breed contagion with other markets where the “carry trade” has been bolstered by leveraged investment flows.

Where next for stocks?

The New York Fed – Business Leaders Survey showed that, despite easing energy costs and benign inflation, business leaders expectations are not particularly robust:-

The Federal Reserve Bank of New York’s December 2014 Business Leaders Survey indicates that activity in the region’s service sector expanded modestly. The survey’s headline business activity index fell ten points to 7.8, indicating a slower pace of growth than in November. The business climate index inched down two points to -7.8, suggesting that on balance, respondents continued to view the business climate as worse than normal. The employment index climbed three points to 16.3, pointing to solid gains in employment, while the wages index drifted down five points to 25.6. After declining sharply last month, the prices paid index climbed four points to 42.2, indicating a slight pickup in the pace of input price increases, while the prices received index fell eight points to its lowest level in two years, at 5.4, pointing to a slowing of selling price increases. The current capital spending index declined ten points to 10.1, while the index for future capital spending rose six points to 25.0. Indexes for the six-month outlook for business activity and employment fell noticeably from last month, suggesting that firms were less optimistic about future conditions.

Set against this rather negative report from the Fed, is this upbeat assessment of the longer-term prospects for US manufacturing from the Peterson Institute – The US Manufacturing Base:

Four Signs of Strength it makes a compelling case for an industrial renaissance in the US. The four signs are:-

  1. US manufacturing output growth
  2. US manufacturing competitive performance relative to other sectors of the US economy
  3. US manufacturing productivity growth relative to other countries
  4. New evidence on outward expansion by US multinational corporations and economic activity by those same firms at home

Another factor supporting the stock market over the last few years has been the steady increase in dividends and share buybacks. According to Birinyi Associates, US corporations bought back $338.3bln of stock in H1 2014 – the most in any six month period since 2007. Here are some of the bigger names; although they account for less than half the H1 total:-

Name Ticker Buyback $blns
Apple APPL 32.9
IBM IBM 19.5
Exxon Mobil XOM 13.2
Pfizer PFE 10.9
Cisco CSCO 9.9
Oracle ORCL 9.8
Home Depot HD 7.6
Wells Fargo WFC 7.5
Microsoft MSFT 7.3
Qualcomm QCOM 6.7
Walt Disney DIS 6.5
Goldman Sachs GS 6.4

Source: Barclays and Wall Street Journal

Share buybacks are running at around twice their long run average and dividends have increased by 12% in the past year. On average, companies spend around 85% of their profits on dividends and share repurchases. This October 6th article from Bloomberg – S&P 500 Companies Spend 95% of Profits on Buybacks, Payouts goes into greater detail, but this particular section caught my eye:-

CEOs have increased the proportion of cash flow allocated to stock buybacks to more than 30 percent, almost double where it was in 2002, data from Barclays show. During the same period, the portion used for capital spending has fallen to about 40 percent from more than 50 percent.

The reluctance to raise capital investment has left companies with the oldest plants and equipment in almost 60 years. The average age of fixed assets reached 22 years in 2013, the highest level since 1956, according to annual data compiled by the Commerce Department.

I am cynical about share buybacks. If they are running at twice the average pace this suggests, firstly, that the “C suite” are more interested in their share options than their shareholders and, secondly, that they are still uncomfortable making capital expenditure decisions due to an utter lack of imagination and/or uncertainty about the political and economic outlook. Either way, this behaviour is not a positive long-term phenomenon. I hope it is mainly a response to the unorthodox policies of the Fed: and that there will be a resurgence in investment spending once interest rates normalise. This might also arrive sooner than expected due to a collapse in inflation rather than a rise in official rates.

The US economy will benefit from lower energy prices in the long term but the rebalancing away from the energy sector is likely to take time, during which the stock market will have difficulty moving higher. For the first time since 2008, the risks are on the downside as we head into 2015. Sector rotation is certainly going to feature prominently next year.

Last weeks National Association of Manufacturers – Monday Economic Report – 8th December 2014 shows the optimism of the manufacturing sector:-

Business leaders continue to reflect optimism about the coming months, with 91.2 percent of survey respondents saying they are either somewhat or very positive about their own company’s outlook. Moreover, manufacturers predict growth of 4.5 percent in sales and 2.1 percent in employment over the next 12 months, with both experiencing the strongest pace in at least two years. 

These findings were largely consistent with other indicators released last week. Most notably, the U.S. economy added 321,000 nonfarm payroll employees on net in November. This was well above the consensus estimate, and it was the fastest monthly pace since April 2011. Hiring in the manufacturing sector was also strong, with 28,000 new workers during the month. Since January, manufacturers have hired almost 15,000 workers on average each month, or 740,000 total since the end of 2009. In other news, manufacturing construction spending was also up sharply, increasing 3.4 percent in October and a whopping 23.0 percent year-over-year. 

These reports suggest that accelerating growth in demand and output is beginning to translate into healthier employment and construction figures, with businesses stepping up investments, perhaps as a sign of confidence. This should bode well for manufacturing employment as we move into 2015. In particular, the Institute for Supply Management’s (ISM) manufacturing Purchasing Managers’ Index (PMI) remains strong, despite edging marginally lower in November. For instance, the production index has now been 60 or higher, which indicates robust expansionary levels, for seven straight months. Similarly, the new orders index has been 60 or higher for five consecutive months, and the export measure also noted some improvements for the month. 

Speaking of exports, the U.S. trade deficit changed little in October, edging marginally lower from the month before. Still, growth in goods exports was somewhat better than the headline figure suggested, with the value of petroleum exports declining on lower crude oil costs. The good news is that year-to-date manufactured goods exports have increased to each of our top-five trading partners so far this year.

They go on to temper this rosy scenario, which is why I anticipate the interruption to the smooth course of stock market returns during the next year :-

…growth in manufactured goods exports remains sluggish through the first 11 months of 2014, up just 1.1 percent relative to the same time frame in 2013. Not surprisingly, challenges abroad continue to dampen our ability to grow international sales.  New factory orders have declined for the third straight month, a disappointing figure particularly given the strength seen in other measures. In addition, the NAM/IndustryWeek survey noted that the expected pace of exports decelerated once again, mirroring the slow growth in manufactured goods exports noted above.

This week saw the release of revised Industrial Production and Capacity Utilisation data – this was the commentary from the Federal Reserve:-

Industrial production increased 1.3 percent in November after edging up in October; output is now reported to have risen at a faster pace over the period from June through October than previously published. In November, manufacturing output increased 1.1 percent, with widespread gains among industries. The rise in factory output was well above its average monthly pace of 0.3 percent over the previous five months and was its largest gain since February. In November, the output of utilities jumped 5.1 percent, as weather that was colder than usual for the month boosted demand for heating. The index for mining decreased 0.1 percent. At 106.7 percent of its 2007 average, total industrial production in November was 5.2 percent above its year-earlier level. Capacity utilization for the industrial sector increased 0.8 percentage point in November to 80.1 percent, a rate equal to its long-run (1972–2013) average.

This paints a positive picture but, with Capacity Utilisation only returning to its long-run trend rate, I remain concerned that the weakness of the energy sector will undermine the, still nascent, recovery in the broader economy in the near-term.

Conclusion and investment opportunities

The decline in the oil price, if it holds, should have a long-term benign effect on US growth and inflation. In the shorter term, however, the rebalancing of the economy away from the energy sector may take its toll, not just on the energy sector, but also on financial services – both the banks, which have lent the energy companies money, and the investors, who have purchased energy related debt. This will breed contagion with other speculative investment markets – lower quality bonds, small cap growth stocks and leveraged derivative investments of many colours.

Where the US stock market leads it is difficult for the rest of the world not to follow. The table below from March 2008 shows the high degree of monthly correlation of a range of stock indices to the Nasdaq Composite. In a QE determined world, I would expect these correlations to have risen over the last six years: –

Ticker Index Country 10 years 5 years 1 year
^IXIC Nasdaq Composite USA 1 1 1
^GSPC S&P 500 USA 0.8 0.86 0.83
^DWC Wilshire 5000 USA N/A 0.9 0.85
^AORD All Ords Australia 0.64 0.6 0.93
^BVSP Bovespa Brazil 0.62 0.53 0.83
^GSPTSE TSX Canada N/A 0.66 0.83
399300.SZ Shanghai Composite China N/A N/A 0.68
^GDAXI DAX Germany N/A 0.73 0.83
^HSI Hang Seng Hong Kong 0.6 0.54 0.79
^BSESN BSE Sensex India 0.44 0.5 0.75
^N225 Nikkei 225 Japan 0.51 0.49 0.87
^MXX IPC Mexico 0.67 0.56 0.33
RTS.RS RTS Russia N/A N/A 0.53
^KS11 Kospi South Korea 0.57 0.59 0.8
^FTSE FTSE100 UK N/A 0.57 0.87

Source: Timingcube.com

A decline in the S&P 500 will impact other developed markets, especially those reliant on the US for exports. 2015 will be a transitional year if oil prices remain depressed at current levels, yet the longer term benefit of lower energy prices will feed through to a recovery in 2016/2017. A crisis could ensue next year, but, with China, Japan and the EU continuing to provide quantitative and qualitative support, I do not believe the world’s “saviour” central banks are “pushing on a string” just yet. Inflation is likely to fall, global growth will be higher, but US stocks will, at best, mark time in 2015.

In bond markets, credit will generally be re-priced to reflect the increased risk of corporate defaults due to mal-investment in the energy sector. Carry trades will be unwound, favouring government bonds to some degree.

Recently heightened expectations of higher short term interest rates will recede. This should be supportive for the Real-Estate market. With a presidential election due in 2016 both the Democrats and the Republicans will be concocting policies to support house prices, jobs, average wages and the value of 401k’s. After three years of deliberation, the introduction of watered down QRM – Qualified Residential Mortgage – rules in October suggests this process is already in train.

Many investors have been waiting to enter the stock market, fearing that the end of QE would herald a substantial correction. 2015 might provide the opportunity but by 2016 I believe this window will have closed.

The US$ as a store of value


Macro Letter – No 20 – 26-09-2014

The US$ as a store of value

  • The US$ Index has broken above July 2013 highs as the US economy strengthens
  • The Trade Weighted Index also reflects this trend
  • But the Trade Balance remains in deficit

US$ Index - 25yr - Barchart.com


Source: Barchart.com

As the US economic recovery continues to gather momentum, what are the prospects for the US$ versus its principal trading partners? This is key to determining how swiftly and to what degree the Federal Reserve will tighten monetary conditions. Above is a 25 year monthly chart of the US$ Index and for comparison, below is the US$ Trade Weighted Index (TWI) as calculated by the Philadelphia Federal Reserve. The TWI shows the initial flight to quality during the onset of the Great Recession, the subsequent collapse as the Fed embarked on its increasingly aggressive programme of QE, followed by a more orderly recovery as the US economy began its long, slow rebound. It is still only a modest recovery and I would not be surprised to see a slow grind higher towards the initial post crisis highs around 113 – this is only a 50% retracement of the 2001-2011 range. In the longer term a return to the “strong dollar” policies of the late 1990’s might be conceivable if the current industrial renaissance of the US continues to gather momentum:-

US$ TWI - 1995-2014 - St Louis Fed

Source: St Louis Federal Reserve

During the late 1990’s the US$ soared on a combination of strong economic growth, a technology asset bubble and relatively benign inflation due to the disinflationary forces of globalisation, emanating especially from China. During the current decade another technology revolution has been underway as the US becomes self-sufficient in energy production. I am not referring simply to “fracking” as this paper from the Manhattan Institute – New Technology for Old Fuel – April 2013 explains: –

Between 1949 and 2010, thanks to improved technology, oil and gas drillers reduced the number of dry holes drilled from 34 percent to 11 percent.

Global spending on oil and gas exploration dwarfs what is spent on “clean” energy. In 2012 alone, drilling expenditures were about $1.2 trillion, nearly 4.5 times the amount spent on alternative energy projects.

Despite more than a century of claims that the world is running out of oil and gas, estimates of available resources continue rising because of innovation. In 2009, the International Energy Agency more than doubled its prior-year estimate of global gas resources, to some 30,000 trillion cubic feet—enough gas to last for nearly three centuries at current rates of consumption.

In 1980, the world had about 683 billion barrels of proved reserves. Between 1980 and 2011, residents of the planet consumed about 800 billion barrels of oil. Yet in 2011, global proved oil reserves stood at 1.6 trillion barrels, an increase of 130 percent over the level recorded in 1980.

The dramatic increase in oil and gas resources is the result of a century of improvements to older technologies such as drill rigs and drill bits, along with better seismic tools, advances in materials science, better robots, more capable submarines, and, of course, cheaper computing power.

 The productivity gains are substantial within the Oil and Gas industry but the benefits are just beginning to percolate out to the broader economy.

Here is US GDP over the last twenty years: –

US GDP - 1995-2014 - Trading Economics

Source: Trading Economics

Growth since the Great Recession has been relatively anaemic. To understand some of the other influences on the US$ we also need to consider the US Trade Balance: –

US Trade Balance - 1995-2014 - Trading Economics

Source: Trading Economics

The USA continues to be the “consumer of last resort”. Here, by contrast are the EU GDP (1995-2014) and Trade Balance (1999-2014): –

EU GDP 1995-2014 - Trading Economics

Source: Trading Economics

EU Trade Balance - 1999-2014 - Trading Economics

Source: Trading Economics

Europe is also a major export market for Chinese goods but nonetheless appears to rely on trade surpluses to generate sustainable growth. Since the Great Recession the EU has struggled to achieve any lasting GDP growth despite a significant increase in its trade surplus. This is because a large part of the terms of trade improvement has been achieved by reducing imports rather than increasing exports, especially in the Euro Zone (EZ) peripheral countries. The austerity imposed on EZ members by the ECB has encouraged some external trade but the prospect for any sustained recovery in EZ growth is limited.

China has, of course, been a major beneficiary of the US trade deficit, although, since the Great Recession, trade surplus data has become significantly more volatile: –

China Trade balance - 1995-2014 - Trading Economics

Source: Trading Economics

The chart above doesn’t really articulate the colossal increase in Chinese exports – between 2004 and 2009 China’s trade surplus increased ten-fold. Despite the more recent policy of “Rebalancing” towards domestic consumption, the latest data takes this surplus to a new record.

The US response to the trade deficit

The US government is concerned about the structural nature of their trade deficit but this is balanced by capital account surpluses as this report from the Congressional Research Service – Financing the U.S. Trade Deficit – March 2014 explains: –

According to the most commonly accepted approach to the balance of payments, macroeconomic developments in the U.S. economy are the major driving forces behind the magnitudes of capital flows, because the macroeconomic factors determine the overall demand for and supply of capital in the economy. Economists generally conclude that the rise in capital inflows can be attributed to comparatively favorable returns on investments in the United States when adjusted for risk, a surplus of saving in other areas of the world, the well-developed U.S. financial system, the overall stability of the U.S. economy, and the generally held view that U.S. securities, especially Treasury securities, are high quality financial instruments that are low risk. In turn, these net capital inflows (inflows net of outflows) bridge the gap in the United States between the amount of credit demanded and the domestic supply of funds, likely keeping U.S. interest rates below the level they would have reached without the foreign capital. These capital inflows also allow the United States to spend beyond its means, including financing its trade deficit, because foreigners are willing to lend to the United States in the form of exchanging goods, represented by U.S. imports, for such U.S. assets as stocks, bonds, U.S. Treasury securities, and real estate and U.S. businesses.

The chart below shows the continued increase in foreign holdings of US assets between 1994 and 2012: –


Source: US Commerce Department

The Congressional Research Service concludes:-

The persistent U.S. trade deficit raises concerns in Congress and elsewhere due to the potential risks such deficits may pose for the long term rate of growth for the economy. In particular, some observers are concerned that foreigner investors’ portfolios will become saturated with dollar denominated assets and foreign investors will become unwilling to accommodate the trade deficit by holding more dollar-denominated assets. The shift in 2004 in the balance of payments toward a larger share of assets being acquired by official sources generated speculation that foreign private investors had indeed reached the point where they were no longer willing to add more dollar-denominated assets to their portfolios. This shift was reversed in 2005, however, as foreign private investments rebounded.

Another concern is with the outflow of profits that arise from the dollar-denominated assets owned by foreign investors. This outflow stems from the profits or interest generated by the assets and represent a clear outflow of capital from the economy that otherwise would not occur if the assets were owned by U.S. investors. These capital outflows represent the most tangible cost to the economy of the present mix of economic policies in which foreign capital inflows are needed to fill the gap between the demand for capital in the economy and the domestic supply of capital.

Indeed, as the data presented indicate, it is important to consider the underlying cause of the trade deficit. According to the most commonly accepted economic approach, in a world with floating exchange rates and the free flow of large amounts dollars in the world economy and international access to dollar-denominated assets, macroeconomic developments, particularly the demand for and supply of credit in the economy, are the driving forces behind the movements in the dollar’s international exchange rate and, therefore, the price of exports and imports in the economy. As a result, according to this approach, the trade deficit is a reflection of macroeconomic conditions addressing the underlying macroeconomic factors in the economy likely would prove to be of limited effectiveness

In addition, the nation’s net international investment position indicates that the largest share of U.S. assets owned by foreigners is held by private investors who acquired the assets for any number of reasons. As a result, the United States is not in debt to foreign investors or to foreign governments similar to some developing countries that run into balance of payments problems, because the United States has not borrowed to finance its trade deficit. Instead the United States has traded assets with foreign investors who are prepared to gain or lose on their investments in the same way private U.S. investors can gain or lose. It is certainly possible that foreign investors, whether they are private or official, could eventually decide to limit their continued acquisition of dollar-denominated assets or even reduce the size of their holdings, but there is no firm evidence that such presently is the case.

The author appears to be saying that, so long as foreign private investors are prepared to continue acquiring US assets, the US need not be overly concerned about the deficit. Given that this should be negative for the US, what are the medium-term implications for the US$?

Gold vs US$

Evaluating the US$, in a world where all the major fiat currencies are attempting to competitively devalue, is fraught with difficulty, however, the price of gold gives some indication of market perceptions. It seems to indicate a resurgence of faith in the US currency:-

Gold - 25 year - Barchart

Source: Barchart.com

The substantial appreciation in the price of gold since 2001 is evident in the chart above, however, since the US economy began to recover from the Great Recession and financial markets perceived that QE3 might suffice to avert deflation, gold has lost some of its “safe-haven” shine. 10 yr US Treasuries yield 2.56%, the S&P 500 dividend yield is 1.87% – whilst these are historically low they look attractive compared to 10 yr German Bunds at 0.97% or 10 yr JGBs at 0.54%.

Leading Indicators

The Philadelphia Federal Reserve – Leading Indicators shows the breadth and depth of the prospects for the US economy, below is their latest heat map: –


Source: Philadelphia Federal Reserve

Below is a chart of the evolution of US Leading Indicators since 1995: –

US Leading Indicators 1995-2014 - St Louis Fed

Source: St Louis Federal Reserve

The relative strength of the Leading Indicators has not been as evident in the GDP data. This supports arguments such as CEPR – Is US economic growth over? September 2012 by Robert Gordon in which he promulgates his theory of structurally lower productivity growth in the US over the coming decades.

Personally I am not convinced that we have seen the end of productivity growth. I believe the extraordinary improvements in energy technology and productivity will begin to show up in broader data over the next few years.

Which leads me back to pondering on Governor Yellen’s recent comments after the FOMC Press Conference:-

…If we were only to shrink our balance sheet by ceasing reinvestments, it would probably take, to get back to levels of reserve balances that we had before the crisis. I’m not sure we will go that low but we’ve said that we will try to shrink our balance sheet to the lowest levels consistent with the efficient and effective implementation of policy. It could take to the end of the decade to achieve those levels.

This suggests the Federal Reserve may never sell any of the assets they have purchased but simply hold them to maturity. In an oblique way this view is supported by a paper from the Chicago Federal Reserve – Measuring fiscal impetus: The Great Recession in historical context which was published this week. They examine the link between changes in fiscal policy in the immediate wake of the Great Recession and more recently the slow pace of this cyclical recovery. Looking forward they opine: –

Fiscal policy during the Great Recession was more expansionary than in the average post-1960 recession, with declines in taxes, increased in transfers, and higher purchases all contributing to higher than typical fiscalimpetus. This pattern reversed itself following the cyclical trough, with declining purchases, particularly among subnational governments, accounting for most of the shortfall. By mid-2012, cumulative fiscal impetus was below the average level in other post-1960 recessions. Although fiscal restraint is expected to ease somewhat over the coming years, there is no indication that fiscal policy will be a meaningful source of economic growth in the near future.

If fiscal policy is unlikely to be a meaningful source of economic stimulus in the near future then monetary policy will have to do the lion’s share of the heavy lifting.

Where next for the US$

The economic fundamentals of the US economy look solid. Regions like Texas might even be in danger of overheating as this report from the Dallas Federal Reserve – Regional Growth: Full Steam Ahead – makes clear:-

The regional economy is surging, with the Texas Business Outlook Survey (TBOS) production and revenue indexes at multiyear highs and annualized job growth of 3.6 percent year to date. Second-quarter job growth was 4.6 percent annualized, and July job growth was just as fast. Energy production continues to increase, and the rig count has risen since last August in spite of a decline in oil prices. Texas exports rebounded in July.

… All told, the regional economy is growing at an unsustainable pace. Texas employment has grown at more than twice its long-run average rate over the past four months. Declines in unemployment measures have slowed, suggesting Texas is near full employment and slack is being depleted. The rapid growth has led to labor shortages, which can cause bottlenecks in production and hurt productivity. Tight labor and housing markets are leading to mounting wage pressures and increasing prices.

Dallas Federal Reserve President Richard Fisher has been a hawk for as long as I can remember, however, he plans to retire in April of next year. As does his fellow hawk Charles Plosser – President of the Philadelphia Fed, although Jeffrey Lacker – President of the Richmond Fed – will take up the hawkish cause in 2015. Nonetheless this weakens to case for any rapid tightening of policy beyond the tapering of QE.

Given the zero bound interest rate policies of all the major central banks, growth rather than expectations of widening interest rate differentials is more likely to determine the direction of currencies. Therefore, the slower the Federal Reserve act in tightening policy, the stronger the momentum of US GDP growth, the larger the capital inflows and the stronger the support for the US$.

Elsewhere, the prospects for EU growth are much weaker. Further QE is imminent after last week’s disappointing uptake of TLTRO funds – Bruegal – T.L.T.R.O. is Too Low To Resuscitate Optimism has more detail. The BoJ, meanwhile, continues with its policy of QQE yet, without the Third Arrow of the Abenomics – serious structural reform – Japan is unlikely to become an engine of economic growth. China continues its rebalancing but the momentum of growth is downward. In this environment the US looks like a land of opportunity to the optimist and the “least worst” safe-haven in an uncertain world for the pessimist. Either way, barring a substantial escalation in direct geopolitical risk, the US$ is unlikely to weaken. Technically the currency is looks set to appreciate further; in so doing this may create a virtuous circle reducing import price inflation and delaying – or possibly mitigating the need for – tightening by the Federal Reserve.

Will the next phase of easing be “qualitative” ? Purchasing common stock


  • How can central banks normalise interest rates without puncturing the recovery?
  • Will long-term capital smooth the economic cycle?
  • What does “qualitative easing” mean for equities?


Last month saw the release of a report by the OMFIF – Global Public Investors – the new force in markets.These quotes are from their press release:-

Central banks around the world, including in Europe, are buying increasing volumes of equities as part of diversification by official asset holders that are now a global force on international capital markets. This is among the findings of Global Public Investor (GPI) 2014, the first comprehensive survey of $29.1tn worth of investments held by 400 public sector institutions in 162 countries.

The report, focusing on investments by 157 central banks, 156 public pension funds and 87 sovereign funds, underlines growing similarities among different categories of public entities owning assets equivalent to 40% of world output.

…One of the reasons for the move into equities reflects central banks’ efforts to compensate for  lost revenue on their reserves, caused by sharp falls in interest rates driven by official institutions’ own efforts to repair the financial crisis. According to OMFIF calculations, based partly on extrapolations from published central bank data, central banks around the world have foregone $200bn to $250bn in interest income as a result of the fall in bond yields in recent years.

…The survey emphasises the two-edged nature of large volumes of extra liquidity held by GPIs. These assets have been built up partly as a result of efforts to alleviate the financial crisis, through foreign exchange intervention by central banks in emerging market economies or quantitative easing by central banks in the main developed countries. But deployment of these funds on capital markets can drive up asset prices and is thus a source of further risks. ‘Many of these challenges [faced by public entities] are self-feeding’, the report says. ‘The same authorities that are responsible for maintaining financial stability are often the owners of the large funds that have the potential to cause problems.’

The report looks at Sovereign Wealth and Pension Funds as well as Central Banks but the trend towards diversification into equities should not be a surprise. In many countries official interest rates are below even official measures of inflation. It is a long time since government bonds were capable of providing sufficient income to match long term liabilities, but the recent fall in interest rates since the great financial recession has forced these institutions to diversify into higher risk assets.

China’s SAFE (State Administration for Foreign Exchange) has now become the world’s largest holder of publicly traded equities. They have established minority stakes in a number of European companies. Central Banking Publications found that 23 percent of Central Banks surveyed said they own shares or plan to buy them. Back in April the BoJ said it will more than double investments in equity exchange-traded funds to 3.5 trl yen this year.  Abe’s third arrow is looking feeble – buying a basket of Nikkei 225 names would be an expedient solution to his political woes.

The BIS – 84th Annual Report – released last week, focussed on the need to move away from debt:-

The main long-term challenge is to adjust policy frameworks so as to promote healthy and sustainable growth. This means two interrelated things.

The first is to recognise that the only way to sustainably strengthen growth is to work on structural reforms that raise productivity and build the economy’s resilience.

…The second, more novel, challenge is to adjust policy frameworks so as to address the financial cycle more systematically. Frameworks that fail to get the financial cycle on the radar screen may inadvertently overreact to short-term developments in output and inflation, generating bigger problems down the road. More generally, asymmetrical policies over successive business and financial cycles can impart a serious bias over time and run the risk of entrenching instability in the economy. Policy does not lean against the booms but eases aggressively and persistently during busts. This induces a downward bias in interest rates and an upward bias in debt levels, which in turn makes it hard to raise rates without damaging the economy – a debt trap.

… In the longer term, the main task is to adjust policy frameworks so as to make growth less debt-dependent and to tame the destructive power of the financial cycle. More symmetrical macroeconomic and prudential policies over that cycle would avoid a persistent easing bias that, over time, can entrench instability and exhaust the policy room for manoeuvre.

The BIS doesn’t go so far as to promote the idea of central banks buying common stock but neither does it imply that this policy would meet with many objections from the central bankers central bank.

For a more radical argument in favour of central bank buying of common stock I am indebted to Prof. Roger Farmer of UCLA –  Qualitative easing: a new tool for the stabilisation of financial markets. In this speech, given at the Bank of England –John Flemming Memorial Lecture last October, Prof. Farmer elaborated on his ideas about “Qualitative Easing”: –

 …When I refer to quantitative easing I mean a large asset purchase by a central bank, paid for by printing money. By qualitative easing, I mean a change in the asset composition of the central Bank.

…In this talk I argue that qualitative easing is a fiscal policy and it is a tool that should be permanently adopted by national treasuries as a means of maintaining financial stability and reducing persistent long-term unemployment.

…My proposed policy tool follows directly from my research findings of the past twelve years. Those findings demonstrate that, by trading in asset markets, national treasuries can and should act to prevent swings in asset prices that have had such destructive effects on all of our lives.

…asset market volatility and unemployment are closely correlated and I will argue that by stabilising asset markets, we can maintain demand and prevent the spectre of persistent unemployment.

…Although there are very good arguments for the use of government expenditure to repair infrastructure during recessions, we should not rely on countercyclical government investment expenditure as our primary tool to stabilise business cycles. Qualitative easing is an effective and more efficient alternative.

…The crisis was caused by inefficient financial markets that led to a fear that financial assets were overvalued. When businessmen and women are afraid, they stop investing in the real economy. Lack of confidence is reflected in low and volatile asset values. Investors become afraid that stocks, and the values of the machines and factories that back those stocks, may fall further. Fear feeds on itself, and the prediction that stocks will lose value becomes self-fulfilling.

…My work demonstrates that the instability of financial markets is not just a reflection of inevitable fluctuations in productive capacity; it is a causal factor in generating high unemployment and persistent stagnation. The remedy is to design an institution, modelled on the modern central bank, with both the authority and the tools to stabilise aggregate fluctuations in the stock market.

These arguments are the heady stuff of political economy and put me in mind of the two views epitomised by the quotes below: –

“Centralization of the means of production and socialization of labor at last reach a point where they become incompatible with their capitalist integument. Thus integument is burst asunder. The knell of capitalist private property sounds. The expropriators are expropriated.”

Karl Marx – Das capital- 1867


“The traditional, correct pre-Marxist view on exploitation was that of radical laissez-faire liberalism as espoused by, for instance, Charles Comte and Charles Dunoyer. According to them, antagonistic interests do not exist between capitalists, as owners of factors of production, and laborers, but between, on the one hand, the producers in society, i.e., homesteaders, producers and contractors, including businessmen as well as workers, and on the other hand, those who acquire wealth non-productively and/or non-contractually, i.e., the state and state-privileged groups, such as feudal landlords.”

Hans-Hermann Hoppe – The Economics and Ethics of Private Property – 1993

There is a precedent for aggressive central bank intervention in equity markets. In August 1998 the HKMA responded to the forth wave of speculative attacks on the currency peg by buying equities. During the second half of August 1998 the HKMA, through its Exchange Fund, bought HK$118 bln (US$15bln) of Hang Seng constituent stocks – 8% of the total market capitalisation. It also intervened in the Hang Seng futures market, creating a violent short squeeze.  In order to further discourage speculators the HKMA mandated the prompt settlement of all outstanding trades, forcing naked short sellers to source stock loans. Having given the speculators a few days to get their stock borrow in place it then imposed a short selling ban on some of the more liquid names.

The Exchange Fund disposed of some of its holding, bringing the percentage of the Hang Seng it held down to 5.3% by 2003. By 2006 it had crept back up to more than 10%. The Exchange Fund currently manages HK$3032.8bln and is permitted to hold up to 20% in equities. According to the HKMA- 2013 Annual Report they held HK$ 153bln of Hong Kong equities and HK$ 297bln of US equities.

The Future of Central Banking

The developed world’s savers are being decimated to fund the profligacy of borrowers. Polonius’s advice to his son today would surely be “Never a lender, always a borrower be.”Major central banks are struggling with this dilemma. Interest rates are close to the zero bound in most developed countries. These are negative real-rates of return. At some point interest rates need to normalise, but the markets are hooked on the methadone of cheap and plentiful money.  Taking away the punchbowl is the central banker remedy for an “Inflation Party”, closing the cocktail bar in the current environment would risk sending the world economy “cold turkey” and potentially killing the patient.

I believe we will see more central bank buying of agency bonds, corporate debt, including convertibles and finally common stock. The objective will be to maintain stability of employment in the wider economy and provide long term capital to support economic growth. This will favour certain companies: –

  1. Large employers – the primary objective is “full employment”
  2. Large capitalisation names – even if the purchases are evenly weighted it will favour the largest stocks by market capitalisation
  3. Non-financial firms – the secondary objective is to supply capital to the real-economy, financial institutions are principally intermediaries
  4. Industries where trade union membership is higher – due to greater political influence
  5. Industries which are the favoured recipients of state subsidies and patronage

The “dispossessed” will be: smaller listed and non-listed companies.

Implications for asset allocation

Where the central banks lead I believe we should follow. Bond yields will inevitably rise as interest rates normalise and institutions switch increasing quantities of their assets to equities. As bond yields rise the attraction of real-estate will diminish due to increased financing costs – though I would make the caveat that property is always about “location”. Equities will benefit from a world-wide, state-sponsored version of the “Greenspan Put”. This doesn’t mean that stock markets will be a one way bet, but valuation models need to incorporate the prospect of this newly minted “wall of money” into their calculations of what represents “value”.

Remember, also, that there will be two distinct types of central bank investment: that which is designed to support domestic employment and that which is driven by the quest for an acceptable rate of return. Many common stocks now offer a higher dividend yield than government bonds, a situation which has not been seen for several decades. In a low inflation environment this should persist, but in pursuit of their inflation targets central banks are likely to distort this relationship once more. It is hard to dispute that this looks like a variant of the Cantillon Effect.

Implementing structural reform is politically difficult, mandating ones central bank to buy the stock market is much easier. There will be pockets of resistance from those who question whether it is appropriate for central banks to control the equity market but this is the least painful exit from the current impasse. The foreign exchange reserves of emerging market central banks have ballooned since the 1997/1998 Asian crisis. Their governments mercantilist policies rely on developed market consumption. Come the next major crisis, it won’t be just the “big five” central banks acting in isolation a concert party of elite capital will save the day.