The Economic Future of a Negative Interest Rate World
In this second AIER article I look at the wider implications of negative interest rates.
To read the previous article, please click here
In this second AIER article I look at the wider implications of negative interest rates.
To read the previous article, please click here
Macro Letter – No 122 – 18-10-2019
Fragility – what the US money-market squeeze means for the future
At the end of October the Federal Reserve are expected to announce the details of their latest balance sheet expansion, this will follow the FOMC meeting. Fed watchers estimate the central bank will buy between $250bln and $330bln of Treasury bills in their effort to provide sufficient reserves to keep the benchmark Effective Federal Funds Rate (EFFR) within its target range. The allocation of liquidity is unlikely to be even, but the Fed has indicated that it will purchase $60bln/month and that they will continue until at least Q2 2020. They are making an unequivocal statement. Let us not forget that it is the traditional function of a central bank, to lend freely against good collateral. The fact that estimates do not exceed $330bln is due to perception that the Fed will not wish the markets to regard these money-market operations as tantamount to QE.
The markets are feverish with speculation, some commentators calling it a further round of QE, despite official statements to the contrary. The money-markets have been unsettled ever since the cash-crunch which occurred in mid-September. For once I concur with the Fed, that this is the management of liquidity via market operations, it is entirely different from the structural effect of longer-term asset purchases. George Selgin of the Cato Institute has coined the acronym SOAP – Supplementary Organic Asset Purchases – nonetheless, this additional liquidity has the effect of expanding the Fed balance sheet and expanding the monetary base. Perception will be all.
Spikes in overnight lending rates are not unusual, especially around tax payment dates, what is unsettling is the challenge the Fed has encountered trying to keep the EFFR within the Fed Funds target range for several days after the initial squeeze. The implementation of SOAP (or whatever they choose to call it) undoubtedly amounts to a further easing of conditions. The Fed may manage expectations by slowly the pace of easing in official rates, after all, what is the point in lowering official rates only to have your good intentions high-jacked by the money-market?
The chart below shows the Fed Fund Effective Rate over the last year (you will note the spike during September): –
Source: Federal Reserve Bank of New York
At the same time the Secured Overnight Funding Rate (SOFR) spiked more wildly: –
Source: Federal Reserve Bank of New York
It is important to note that, while the EFFR squeezed higher, SOFR actually spiked more than the chart above indicates, rising from 2.19% to 9% on September 17th. The following day the Fed increased its holdings of Repos from $20bln to $53bln, it also officially cut the Fed Funds target rate by 25bp to 1.75%. On Wednesday 18th the Fed Repo balance rose again to $75bln, by Monday 23rd those balances had reached $105bln.
There are numerous theories about the stubbornness of money-market rates to moderate. Daniel Lacalle writing for Mises – The Repo Crisis Shows the Damage Done by Central Bank Policies – observes: –
What the Repo Market Crisis shows us is that liquidity is substantially lower than what the Federal Reserve believes, that fear of contagion and rising risk are evident in the weakest link of the financial repression machine (the overnight market) and, more importantly, that liquidity providers probably have significantly more leverage than many expected.
In summary, the ongoing — and likely to return — burst in the repo market is telling us that risk and debt accumulation are much higher than estimated. Central banks believed they could create a Tsunami of liquidity and manage the waves. However, like those children’s toys where you press one block and another one rises, the repo market is showing us a symptom of debt saturation and massive risk accumulation.
…what financial institutions and investors have hoarded in recent years, high-risk, low-return assets, is more dangerous than many of us believed.
A different opinion about the root of the Repo problem is provided by Alasdair Macleod, also writing for Mises – The Ghosts of Failed Banks Have Returned: –
The reason for its failure has little to do with, as some commentators have suggested, a general liquidity shortage. That argument is challenged by the increase in the Fed’s reverse repos from $230bn in October 2018 to $325bn on 18 September, which would not have been implemented if there was a general shortage of liquidity. Rather, it appears to be a systemic problem; another Northern Rock, but far larger. Today we call such an event a black swan.
The author goes on to suggest that a large non-US bank may be the cause of the issue. Inevitably Deutsche Bank’s name is mentioned.
I believe the issue stems from a number of different factors. Firstly, the Fed is far more central to the banking system today, especially since they elected to pay interest on bank deposits. Secondly, the banks have been wary of lending to corporates, or to one another, they are therefore more beholden to the Fed. Finally, the void created by the banks refusing, or being unable, to lend to the real economy has been filled by private capital, provided by hedge funds, money market funds and synthetic ETFs – these latter instruments have balances in excess of $4trln.
These new sources of funding cannot access the SOFR market directly, they must intermediate with the 24 broker-dealers with whom the Fed transact open market operations. Any hint of a bank being in difficulty will see these shadow-bankers move assets from that institution rapidly, causing the institution concerned (if it can) to make a dash for the Repo market and the succour of the Fed.
Macleod suggests other factors which might have contributed to the SOFR squeeze, including: –
…Chinese groups are shedding $40bn in global assets… domestic funding requirements faced by Saudi Arabia in the wake of the attack on her oil refining facilities, almost certainly being covered by the sale of dollar balances in New York.
…with $307.9bn withdrawn in the year to July, foreign withdrawals appear to be a more widespread problem than exposed by current events.
Enough of speculation, the official explanation is contained in this article from the Chicago Fed – Understanding recent fluctuations in short-term interest rates: –
Two developments in mid-September put stress on overnight funding markets. First, quarterly tax payments for corporations and some individuals were due on September 16. Over a period of a few days, these taxpayers took more than $100 billion out of bank and money market mutual fund accounts and sent the money to the U.S. Treasury. Second, the Treasury increased its long-term debt by $54 billion by paying off maturing securities and issuing a larger quantity of new ones. (A reduction in short-term Treasury bills outstanding partly offset the increase in long-term debt.) Buyers of the new debt paid for it by withdrawing money from bank and money market accounts. Combined with the tax payments, the debt issuance reduced the amount of cash in the financial system.
At the same time as liquidity was diminishing, the Treasury debt issuance caused financial institutions to need more liquidity. A substantial share of newly issued Treasury debt is typically purchased by securities dealers, who then gradually sell the bonds to their customers. Dealers finance their bond inventories by using the bonds as collateral for overnight loans in the repo market. The major lenders of cash in that market include banks and money market funds—the very institutions that had less cash on hand as a result of taxpayers’ and bond buyers’ payments to the Treasury.
With more borrowers chasing a reduced supply of funding in the repo market, repo interest rates began to rise on September 16 and then soared on the morning of September 17, reaching as high as 9% in some transactions—on a day when the FOMC was targeting a range of 2% to 2.25% for the fed funds rate.
Pressures in the repo market then spilled over to other markets, such as fed funds, as lenders in those markets now had the option to chase the high returns available in the repo market. In addition, when banks experience large outflows as a result of tax payments or Treasury issuance, they may seek to make up the money by borrowing overnight in the fed funds and other markets, putting additional pressure on rates there. The fed funds rate reached 2.25%, the top of the FOMC’s target range, on September 16 and 2.30% on September 17.
Here, is a chart showing the change in SOFR and EFFR over the last five years (you will notice that on none of these charts does the transaction struck at 9% ever appear – perhaps they do not want to frighten the horses): –
Source: Chicago Federal Reserve Bank
In their discussion of how the Fed responded (on September 17th) to the squeeze the authors point out: –
…the (Fed) Desk offered $75 billion in repos, primary dealers bid for only $53 billion. On the margin, this meant that primary dealers were forgoing the opportunity to borrow at the operation’s minimum bid rate of 2.1% and lend money into repo markets that were still trading at much higher rates. This outcome suggests that there could be some limits to primary dealers’ willingness to redistribute funding to the broader market.
They suggest that this may be a function of the level of leverage already in the banking system. By September 19th the Fed were compelled to lower the interest rate on excess reserves – IOER. Finally the relationship between EFFR and SOFR returned to its normal range.
According to the authors the Fed have learnt from their hysteresis that adjustments to the IOER are also critical to control of money-markets, repo operations may not be sufficient in isolation. The chart below shows the spread between SOFR and IOER: –
Source: Chicago Federal Reserve Bank
This is how the Fed describes the evolution of the relationship (the emphasis is mine): –
When the repo rate is below the interest rate on reserves, as it generally was from 2015 through March 2018, the supply of liquidity is so great that Treasury securities are very easy to finance and have a lower effective overnight yield than reserves. From March 2018 through March 2019, repo rates were generally very close to the interest rate on reserves. Then, beginning in the second quarter of 2019, repo rates ticked above the interest rate on reserves. Around the same time, money market rates started to exhibit slightly more upward pressure near tax payment deadlines. Most recently, just before the volatility in mid-September, the spread between SOFR and IOER on September 13 was the highest yet on the business day before a tax date in the period since the FOMC began normalizing monetary policy in late 2015.
This confirms my suspicion that since the financial crisis the Fed (and central banks in general) have become far more central to the smooth functioning of the financial markets. Actions such as QE are clear, the function of the lender of last resort is less so. Professor Perry Mehrling’s – The New Lombard Street (published in 2010 the wake of the financial crisis) discusses the changed role of the Fed in detail, it is well worth re-reading.
I normally end my newsletters with an investment proposal. This time my advice is of a different nature. During the financial crisis central banks saved the global financial system, but, as last month’s’ SOFR Squeeze makes clear, the patient is still on life support. The solution to too much debt has been the reduction of interest rates, but, because lower rates make debt financing easier, this has led to an even greater system-wide burden of debt. In the process the role of the central bank has become far more pivotal. They have reaped what they sowed, the financial markets still function, but they remain inherently fragile. If the Fed analysis of the reasons for the price spike are correct, a relatively small imbalance may, on another occasion, derail the entire market.
The advice? Batten down the hatches, maintain excess liquidity and prepare for the next stress-test of the overnight lending market.
Macro Letter – No 121 – 04-10-2019
Value, Momentum and Carry – Is it time for equity investors to switch?
Value, momentum and carry are the three principal means of extracting return from any investment. They may be described in other ways but these are really the only games in town. I was reminded of this during the last month as value based equity managers witnessed a resurgence of performance whilst index tracking products generally suffered. Is this a sea-change or merely a case of what goes up must come back down?
My premise over the last few years has been that the influence of central banks, in reducing interest rates to zero or below, has been the overwhelming driver of return for all asset classes. The stellar performance of government bonds has percolated through the credit markets and into stocks. Lower interest rates has also made financing easier, buoying the price of real-estate.
Traditionally, in the equity markets, investment has been allocated to stocks which offer growth or income, yet with interest rates falling everywhere, dividend yields offer as much or more than bonds, making them attractive, however, growth stocks, often entirely bereft of earnings, become more attractive as financing costs approach zero. In this environment, with asset management fees under increasing pressure, it is not surprising to observe fund investors accessing the stock market by the cheapest possible means, namely ETFs and index tracking funds.
During the last month, there was a change in mood within the stock market. Volatility within individual stocks remains relatively high, amid the geo-political and economic uncertainty, but value based active managers saw a relative resurgence, after several years in the wilderness. This may be merely a short-term correction driven more by a rotation out of the top performing stocks, but it could herald a sea-change. The rising tide of ever lower interest rates, which has floated all ships, may not have turned, but it is at the stand, value, rather than momentum, may be the best means of extracting return in the run up to the US presidential elections.
A review of recent market commentary helps to put this idea in perspective. Firstly, there is the case for growth stocks, eloquently argued by Jack Neele at Robeco – Buying cheap is an expensive business: –
One of the most frequent questions I have been asked in recent years concerns valuation. My focus on long-term growth trends in consumer spending and the companies that can benefit from these often leads me to stocks with high absolute and relative valuations. Stocks of companies with sustainability practices that give them a competitive edge, global brand strength and superior growth prospects are rewarded with an above-average price-earnings ratio.
It is only logical that clients ask questions about high valuations. To start with, you have the well-known value effect. This is the principle that, in the long term, value stocks – adjusted for risk – generate better returns that their growth counterparts. Empirical research has been carried out on this, over long periods, and the effect has been observed in both developed and emerging markets. So if investors want to swim against the tide, they need to have good reasons for doing so.
Source: Robeco, MSCI
In addition, there are – understandably – few investors who tell their clients they have the market’s most expensive stocks in their portfolio. Buying cheap stocks is seen as prudent: a sign of due care. However, if we zoom in on the last ten years, there seems to have been a structural change since the financial crisis. Cheap stocks have done much less well and significantly lagged growth stocks.
Source: Robeco, MSCI
Nevertheless, holding expensive stocks is often deemed speculative or reckless. This is partly because in the financial industry the words ‘expensive’ and ‘overvalued’ are often confused, despite their significant differences. There are many investors who have simply discarded Amazon shares as ‘much too expensive’ in the last ten years. But in that same period, Amazon is up more than 2000%. While the stock might have been expensive ten years ago, with hindsight it certainly wasn’t overvalued.
The same applies for ‘cheap’ and ‘undervalued’. Stocks with a low price-earnings ratio, price-to-book ratio or high dividend yield are classified as cheap, but that doesn’t mean they are undervalued. Companies in the oil and gas, telecommunications, automotive, banking or commodities sectors have belonged to this category for decades. But often it is the stocks of these companies that structurally lag the broader market. Cheap, yes. Undervalued, no.
The author goes on to admit that he is a trend follower – although he actually says trend investor – aside from momentum, he makes two other arguments for growth stocks, firstly low interest rates and secondly the continued march of technology, suggesting that investors have become much better at evaluating intangible assets. The trend away from older industries has been in train for many decades but Neele points out that since 1990 the total Industry sector weighting in the S&P Index has fallen from 34.9% to 17.3% whilst Technology has risen from 5.9% to 15.6%.
If the developed world is going to continue ageing and interest rates remain low, technology is, more than ever, the answer to greatest challenges facing mankind. Why, therefore, should one contemplate switching from momentum to value?
A more quantitative approach to the current environment looks at the volatility of individual stocks relative to the main indices. I am indebted to my good friend Allan Rogers for his analysis of the S&P 100 constituents over the past year: –
OEF, the ETF tracking the S&P 100, increased very modestly during the period from 9/21/2018 to 9/20/2019. It rose from 130.47 to 132.60, a gain of 1.63%. During the 52 weeks, it ranged between 104.23 and 134.33, a range of 28.9% during a period where the VIX rarely exceeded 20%. Despite the inclusion of an additional 400 companies, SPY, the ETF tracking the S&P 500, experienced a comparable range of 29.5%, calculated by dividing the 52 week high of 302.63 by the 52 week low of 233.76. SPY rose by 2.2% during that 52 week period. Why is this significant? Before reading on, pause and make your own estimate of the average 52 week range for the individual stocks in the S&P 100. 15%? 25%? The average 52 week price range for the components was 49%. The smallest range was 18%. The largest range was 134%. For a portfolio manager tasked with attempting to generate a return of 7% per annum, the 100 largest company stocks offer potential profit of seven times the target return if one engages in active trading. Credit risk would appear to be de minimus for this group of companies. This phenomenon highlights remarkable inefficiency in stock market liquidity.
This analysis is not in the public domain, however, please contact me if you would like to engage with the author.
This quantitative approach when approaching the broader topic of factor investing – for a primer Robeco – The Essentials of Factor Investing – is an excellent guide. Many commentators discuss value in relation to investment factors. Last month an article by Olivier d’Assier of Axioma – Has the Factor World Gone Mad and Are We on the Brink of Another Quant Crisis? caught my eye, he begins thus: –
To say that fundamental style factor returns have been unusual this past week would be the understatement of the year—the decade, in fact. As reported in yesterday’s blog post “Momentum Nosedives”, Momentum had a greater-than two standard deviation month-to-date negative return in seven of the eleven markets we track. Conversely, Value, which has been underperforming year-to-date everywhere except Australia and emerging markets, has seen a stronger-than two standard deviation month-to-date positive return in four of those markets. The growth factor also saw a sharp reversal of fortune last week in the US, while leverage had a stronger-than two standard deviation positive return in that market on the hopes for more monetary easing by the Fed.
The author goes on to draw parallels with July 2007, reminding us that after a few weeks of chaotic reversals, the factor relationships returned to trend. This time there is a difference, equities in 2007 were not a yield substitute for bonds, today, they are. Put into the context of geopolitical and economic growth concerns, the author expects lower rates and sees the recent correction in bond yields as corrective rather than structural. As for the recent price action, d’Assier believes this is due to unwinding of exposures, combined with short-term traders buying this year’s losing factors, Value and Dividend Yield, and selling winners such as Momentum and Growth. Incidentally, despite the headline, Axioma does not envisage a quant crisis.
Returning to the broader topic of momentum versus value, a recent article from MSCI – Growth’s recent outperformance was and wasn’t an anomaly – considers whether the last decade represents a structural shift, here is their summary: –
Growth strategies have performed well over the past few years. For investors, an important question is whether the recent performance is an anomaly.
For a growth strategy that simply picks stocks with high growth characteristics, the recent outperformance is out of line with that type of growth strategy’s historical performance.
For a strategy that targets the growth factor while controlling for other factors, the recent outperformance has been in line with its longer historical performance.
The chart below attempts to show the performance of the pure growth factor adjusted for non-growth factors: –
If anything, this chart shows a slightly reduced return from pure growth over the last three years. The authors conclude: –
…to answer whether growth’s recent performance is an anomaly really depends on what we mean by growth. If we mean a simple strategy that selects high-growth stocks, then the recent performance is not representative of that strategy’s long-term historical performance. In this case, we can attribute the recent outperformance relative to the long term to non-growth factors and particular sectors — exposure to which has not been as detrimental recently as it has been over the long run. But for a factor- and sector-controlled growth strategy, the performance is mainly driven by exposure to the growth factor. In this case, the recent outperformance has been in line with the longer-term outperformance.
As I read this I am reminded of a quant hedge fund manager with whom I used to do business back in the early part of the century. He had taken a tried a tested fundamental short-selling strategy and built a market neutral, industry neutral, sector neutral portfolio around it, unfortunately, by the time he had hedged away all these risks, the strategy no longer made any return. What we can probably agree upon is that growth stocks have outperformed income and value not simply because they are growth stocks.
The Case for Value
They say that history is written by the winners, nowhere is this truer than in investment management. Investors move in herds, they want what is hot and not what is not. In a paper published last month by PGIM – Value vs. Growth: The New Bubble – the authors’ made several points, below are edited highlights (the emphasis is mine): –
We have been through an extraordinary period of value factor underperformance over the last 18 months. The only comparable periods over the last 30 years are the Tech Bubble and the GFC.
Historically, we would expect a very sharp reversal of value performance to follow. This was the case in each of the two previous extreme periods.
We tested the drivers of recent value underperformance to see if we are in a “value trap.” Historically, fundamentals have somewhat deteriorated, but prices expected a bigger deterioration, so the bounce-back more than offset the fundamental deterioration. In a value trap environment, we would expect a greater deterioration in fundamentals. In the last 18 months, we have actually seen an improvement in fundamental earnings for value stocks, but a deterioration in pricing. This combination is unprecedented, and signals the opposite of a value trap environment.
…we examined the behavior of corporate insiders… The relative conviction of insiders regarding cheaper stocks is higher than ever, which reinforces our conviction about the magnitude of the performance opportunity from here.
It is never easy to predict what it will take to pop a bubble, but there are multiple scenarios that we envisage as potential catalysts, including both growth and recessionary conditions.
These views echo an August 2019 article by John Pease at GMO – Risk and Premium – A Tale of Value – the author concludes (once again the emphasis is mine): –
Value has underperformed the market in 10 of the last 12 months, including the last 7. Its most recent drawdown began in 2014 and the factor is quite far from its high watermark. The relative return of traditional value has been flat since late 2004. All in all, it has been a harrowing decade for those who have sought cheap stocks, and we have tried to understand why.
We approached this problem by decomposing the factor’s relative returns. The relative growth profile of value has not changed with time; the cheapest half (ex-financials) in the U.S. has continued to undergrow the market, but by no more than what we have come to expect. These companies have also not compromised their quality to keep growth stable, suggesting that any shifts that have occurred in the market have not disproportionately hurt value’s fundamentals.
The offsets to value’s undergrowth, however, have come under pressure. Value’s yield advantage has fallen as the market has become more expensive. The group’s rebalancing – the tendency of cheap companies to see their multiples expand and rotate out of the group while expensive companies see their multiples contract and come into value – is also slower, with behavioral and structural aspects both at play. Though these drivers of relative outperformance have diminished, they still exceed value’s undergrowth by more than 1%, indicating that going forward, cheap stocks (at least as we define them) are likely to reap a decent, albeit smaller, premium.
This premium has not materialized over the last decade for a simple reason: relative valuations. Value has seen its multiples expand a lot less than the market. This makes sense – because value tends to have significantly lower duration than other equities, a broad risk rally shouldn’t be as favorable to cheap stocks as it should be to their expensive counterparts. And we have had quite a rally.
It isn’t possible to guarantee that the next decade will be kinder to value than the previous one was. The odds would seem to favor it, however. Cheap stocks still provide investors with a premium, allowing them to outperform even if their relative valuations remain low. If relative valuations rise – not an inconceivable event given a long history of mean-reverting discount rates – the ensuing relative returns will be exceptional. And value, after quite the pause, might look valuable again.
A key point in this analysis is that the low interest rate environment has favoured growth over value. Unless the next decade sees a significant normalisation of interest rates, unlikely given the demographic headwinds, growth will continue to benefit, even as momentum strategies falter due to the inability of interest rates to fall significantly below zero (and that is by no means certain either).
These Macro Letters would not be In the Long Run without taking a broader perspective and this July 2019 paper by Antti Ilmanen, Ronen Israel, Tobias J. Moskowitz, Ashwin Thapar, and Franklin Wan of AQR – Do Factor Premia Vary Over Time? A Century of Evidence – fits the bill. The author examine four factors – value, momentum, carry, and defensive (which is essentially a beta neutral or hedged portfolio). Here are their conclusions (the emphasis is mine): –
A century of data across six diverse asset classes provides a rich laboratory to investigate whether canonical asset pricing factor premia vary over time. We examine this question from three perspectives: statistical identification, economic theory, and conditioning information. We find that return premia for value, momentum, carry, and defensive are robust and significant in every asset class over the last century. We show that these premia vary significantly over time. We consider a number of economic mechanisms that may drive this variation and find that part of the variation is driven by overfitting of the original sample periods, but find no evidence that informed trading has altered these premia. Appealing to a variety of macroeconomic asset pricing theories, and armed with a century of global economic shocks, we test a number of potential sources for this variation and find very little. We fail to find reliable or consistent evidence of macroeconomic, business cycle, tail risks, or sentiment driving variation in factor premia, challenging many proposed dynamic asset pricing theories. Finally, we analyze conditioning information to forecast future returns and construct timing models that show evidence of predictability from valuation spreads and inverse volatility. The predictability is even stronger when we impose theoretical restrictions on the timing model and combine information from multiple predictors. The evidence identifies significant conditional return premia from these asset pricing factors. However, trading profits to an implementable factor timing strategy are disappointing once we account for real-world implementation issues and costs.
Our results have important implications for asset pricing theory, shedding light on the existence of conditional premia associated with prominent asset pricing factors across many asset classes. The same asset pricing factors that capture unconditional expected returns also seem to explain conditional expected returns, suggesting that the unconditional and conditional stochastic discount factors may not be that different. The lack of explanatory power for macroeconomic models of asset pricing challenges their usefulness in describing the key empirical factors that describe asset price dynamics. However, imposing economic restrictions on multiple pieces of conditioning information better extracts conditional premia from the data. These results offer new features for future asset pricing models to accommodate.
This paper suggests that, in the long run, broad asset risk premia drive returns in a consistent manner. Macroeconomic and business cycle models, which attempt to forecast asset values based on expectations for economic growth, have a lower predictive value.
Conclusions and investment opportunities
I have often read market commentators railing against the market, complaining that asset prices ignored the economic fundamentals, the research from AQR offers a new insight into what drives asset returns over an extended time horizon. Whilst this does not make macroeconomic analysis obsolete it helps to highlight the paramount importance of factor premia in forecasting asset returns.
Returning to the main thrust of this latter, is this the time to switch from momentum to value? I think the jury is still out, although, as the chart below illustrates, we are near an all-time high for the ratio between net worth and disposable income per person in the US: –
Source: Federal Reserve
This is a cause for concern, it points to severe imbalances within households: it is also a measure of rising income inequality. That stated, many indicators are at unusual levels due to the historically low interest rate environment. Investment flows have been the principal driver of asset returns since the great recession, however, now that central bank interest rates in the majority of developed economies are near zero, it is difficult for investors to envisage a dramatic move into negative territory. Fear about an economic slowdown will see risk free government bond yields become more negative, but the longer-term driver of equity market return is no longer solely based on interest rate expectations. A more defensive approach to equities is likely to be seen if a global recession is immanent. Whether growth stocks prove resurgent or falter in the near-term, technology stocks will continue to gain relative to old economy companies, human ingenuity will continue to benefit mankind. Creative destruction, where inefficient enterprises are replaced by new efficient ones, is occurring despite attempts by central banks to slow its progress.
For the present I remain long the index, I continue to favour momentum over value, but, as was the case when I published – Macro Letter – No 93 back in March 2018, I am tempted to reduce exposure or switch to a value based approach, even at the risk of losing out, but then I remember the words of Ryan Shea in his article Artificial Stupidity: –
…investment success depends upon behaving like the rest of the crowd almost all of the time. Acting rational when everyone else is irrational is a losing trading strategy because market prices are determined by the collective interaction of all participants.
For the active portfolio manager, value factors may offer a better risk reward profile, but, given the individual stock volatility dispersion, a market neutral defensive factor model, along the lines proposed by AQR, may deliver the best risk adjusted return of all.
This is the first of two articles about negative real interest rates.
Macro Letter – No 120 – 13-09-2019
Uncertainty and the countdown to the US presidential elections
These are just a few of the news stories which drove financial markets during the summer: –
For financial markets it is a time of heightened uncertainty. The first two articles are provide a commentary on the way markets are evolving. The impact of social media is rising, with Trump in the vanguard. Geopolitical uncertainty and the prospect of fiscal debasement are, meanwhile, upsetting the normally inverse relationship between the price of gold and the US$.
The next two items are more market specific. The stand-off between the Chinese administration and the people of the semi-autonomous enclave of Hong Kong, prompts concern about the political stability of China, meanwhile the US Commander in Chief persists in undermining the credibility of the notionally independent Federal Reserve and seems unable to resist antagonising the Chinese administration as he raises the stakes in the Sino-US trade war. Financial markets have been understandably unsettled.
Ironically, despite the developments high-lighted above, during August, US bonds witnessed sharp reversals lower, suggesting that geopolitical tensions might have moderated. Since the beginning of September prices have rebounded, perhaps there were simply more sellers than buyers last month. In Europe, by contrast, German bunds reached new all-time highs, only to suffer sharp reversal in the past week. Equity markets responded to the political uncertainty in a more consistent manner, plunging and then recovering during the past month. As the chart below illustrates, there has been increasing debate about the challenge of increased volatility since the end of July: –
Yet, as always, it is not the volatility or even risk which presents a challenge to financial market operators, it is uncertainty. Volatility is a measure derived from the mean and variance of a price. It is a cornerstone of the measurement of financial risk: the key point is that it is measurable. Risk is something we can measure, uncertainty is that which we cannot. This is not a new observation, it was first made in 1921 by Frank Knight – Risk, Uncertainty and Profit.
Returning to the current state of the financial markets, we are witnessing a gradual erosion of belief in the omnipotence of central banks. See Macro Letter’s 48, 79 and 94 for some of my previous views. What has changed? As Keynes might have put it, ‘The facts.’ Central Banks, most notably the Bank of Japan, Swiss National Bank and European Central Bank, have been using zero or negative interest rate policy, in conjunction with balance sheet expansion, in a valiant attempt to stimulate aggregate demand. The experiment has been moderately successful, but the economy, rather like a chronic drug addict, requires an ever increasing fix to reach the same high.
In Macro Letter – No 114 – 10-05-2019 – Debasing the Baseless – Modern Monetary Theory – I discussed the latest scientific justification for debasement. My conclusion: –
The radical ideas contained in MMT are unlikely to be adopted in full, but the idea that fiscal expansion is non-inflationary provides succour to profligate politicians of all stripes. Come the next hint of recession, central banks will embark on even more pronounced quantitative and qualitative easing, safe in the knowledge that, should they fail to reignite their economies, government mandated fiscal expansion will come to their aid. Long-term bond yields will head towards the zero-bound – some are there already. Debt to GDP ratios will no longer trouble finance ministers. If stocks decline, central banks will acquire them: and, in the process, the means of production. This will be justified as the provision of permanent capital. Bonds will rise, stocks will rise, real estate will rise. There will be no inflation, except in the price of assets.
As this recent article from the Federal Reserve Bank of San Francisco – Negative Interest Rates and Inflation Expectations in Japan – indicates, even central bankers are beginning to doubt the efficacy of zero or negative interest rates, albeit, these comments emanate from the FRBSF research department rather than the president’s office. If the official narrative, about the efficacy of zero/negative interest rate policy, is beginning to change, state sponsored fiscal stimulus will have to increase dramatically to fill the vacuum. The methadone of zero rates and almost infinite credit will be difficult to quickly replace, I anticipate widespread financial market dislocation on the road to fiscal nirvana.
In the short run, we are entering a period of transition. Trump may continue to berate the chairman of the Federal Reserve and China, but his room for manoeuvre is limited. He needs Mr Market on his side to win the next election. For Europe and Japan the options are even more constrained. Come the next crisis, I anticipate widespread central bank buying of stocks (in addition to government and corporate bonds) in order to provide liquidity and insure economic stability. The rest of the task will fall to the governments. Non-inflationary fiscal profligacy will be de rigueur – I can see the politicians smiling all the way to the hustings, safe in the knowledge that deflationary forces have awarded them a free-lunch. Someone, someday, will have to pay, of course, but they will be long since retired from public office.
Conclusions and Investment Opportunities
During the next year, markets will continue to gyrate erratically, driven by the politics of European budgets, Brexit and the Sino-US trade war. These issues will be eclipsed by the twittering of Donald Trump as he seeks to win a second term in office. Looked at cynically, one might argue that Trump’s foreign policy has been deliberately engineered to slow the US economy and hold back the stock market. During the next 14 months, a new nuclear weapons agreement could be forged with Iran, relations with North Korea improved and a trade deal negotiated with China. Whether this geopolitical largesse is truly in the President’s gift remains unclear, but for a maker of deals such as Mr Trump, the prospect must be tantalising.
For the US$, the countdown to the US election remains positive, for stocks, likewise. For the bond market, the next year may be broadly neutral, but given the signs of faltering growth across the globe, it seems unlikely that yields will rise significantly. Economies will see growth slow, leading to an accelerated pace of debt issuance. Bouts of volatility, similar to August or Q4 2018, will become more commonplace. I remain bullish for asset markets, nonetheless.
As you may have seen elsewhere I have recently been invited to contribute to AIER. This article was first published in June.
AIER also operate the Bastiat Society, a global network of business professionals committed to advancing free trade, individual freedom, and responsible governance. To find a chapter near you please click on the link below: –
Macro Letter – No 119 – 23-08-2019
Chinese currency manipulation – Trump’s petard
According to the US President, the Chinese are an official currency manipulator. Given that they have never relaxed their exchange controls, one must regard Trump’s statement as rhetoric or ignorance. One hopes it is the former.
Sino-US relations have now moved into a new phase, however, on August 5th, after another round of abortive trade discussions, the US Treasury officially designated China a currency manipulator too. This was the first such outburst from the US Treasury in 25 years. One has to question their motivation, as recently as last year the PBoC was intervening to stem the fall in their currency against the US$, hardly an uncharitable act towards the American people. As the Economist – The Trump administration labels China a currency manipulator – described the situation earlier this month (the emphasis is mine): –
After the Trump administration’s announcement of tariffs on August 1st added extra pressure towards devaluation, it seems that the PBOC chose to let market forces work. The policymaker most obviously intervening to push the yuan down against the dollar is Mr Trump himself.
China does not meet the IMF definition of a ‘currency manipulator’ but the US Treasury position is more nuanced. CFR – Is China Manipulating Its Currency? Explains, although they do not see much advantage to the US: –
Legally speaking, the issue of whether China meets the standard for manipulation set out in U.S. law is complex. The 2015 Trade Enforcement Act sets out three criteria a country must meet to be tagged a manipulator: a bilateral surplus with the United States, an overall current account surplus, and one-sided intervention in the foreign-exchange market to suppress the value of its currency. The Treasury Department’s most recent report [PDF] concluded that China only met the bilateral surplus criterion.
But the 1988 Omnibus Foreign Trade and Competiveness Act [PDF] has a different definition of manipulation, saying it can emerge either from action to “[impede] effective balance of payments adjustments” or action to “[gain an] unfair competitive advantage in international trade.” The United States is likely to argue that the recent depreciation was intended to give Chinese exports an edge. China would counter that it has no obligation to resist market pressures pushing the yuan down when the United States implements tariffs that hurt China’s exports.
In the past (2003-2013) China has intervened aggressively to stem the rise of its currency, since then it has intervened in the opposite direction, to the benefit of the US. Earlier this month it briefly appeared to withdrawn from the foreign exchange market, allowing the markets to set their own level based on perceptions of risk. As the Peterson Institute – Trump’s Attack on China’s Currency Policy – puts it: –
This depreciation is due to market forces: Trump’s tariffs push the dollar up against all currencies, the Chinese currency weakens as a result of the trade hit, and China will undoubtedly lower its interest rates to counter that slowdown. There is no evidence that China has sold renminbi for dollars to overtly push its exchange rate down.
Since the inflammatory pop above 7 Yuan to the US$, China has sought to calm frayed nerves, indicating that it wishes to maintain the US$ exchange rate at around current levels: nonetheless, a pre-US election sabre has been rattled.
Speculation about the next move by the Trump administration is, as always, rife, but the consensus suggests the ‘currency manipulator’ label may be used to justify an escalation of US tariffs on Chinese goods. In this new scenario, every tariff increase by the US, will precipitate a decline in the Yuan; it will be a zero-sum game, except for the US importer who will have to foot the bill for the tariffs or pass them on to the consumer. Either a weaker Yuan will mitigate their effect or the tariffs will bite, leading to either a slowdown in consumption or higher prices, or possibly both.
Barring a weaker Yuan, this sequence of events could also threaten the independence of the Federal Reserve. The central bank will be torn between the opposing policies required to meet the dual mandate of price stability and full employment. In the worst case, prices will be rise as employment falls.
Current estimates of the increased cost of tariffs to the US economy are in the region of 10%, yet during the past year the Yuan has already declined from 6.3 to 7 (11%). As the chart below shows, a move back towards 8 Yuan to the US$ cannot be ruled out, enough to significantly eclipse the impact of US tariffs to date: –
Source: Trading Economics
Conclusions and investment opportunities
In the run-up to the November 2020 presidential election, US foreign policy towards China is likely to remain confrontational. China, as always, has the ability to play the long game, although the political tensions evident in Hong Kong may highjack even their gradualist agenda. Either way, the Yuan is liable to weaken, pressurising other Asian currencies to follow suit. The US$ may appear relatively strong of late but, as the chart below shows, it is more than 50% below its 1980’s peak: –
Source: Trading Economics
A move above the 2016 highs at 103 would see the US$ Index push towards the early 2000’s highs at 120.
The US bond yield curve has been steadily inverting, a harbinger, some say, of a recession. The other interpretation is that US official rates are much too high. Relative to other developed nations US Treasury yields certainly offer value. I expect the Fed to cut rates and, if inflation rises above the 2% level, expect them to point to tariff increases as a one-off inflation effect. They will choose to target full-employment over price stability.
Barring a catastrophe in Hong Kong, followed a US military response (neither of which can be entirely ruled out) any risk-off weakening of stocks, offers a buying opportunity. Further down the road, when US 10yr bond yields turn negative, stocks will trade on significantly higher multiples.
Macro Letter – No 118 – 12-06-2019
Low yield, no yield, negative yield – Buy now but don’t forget to sell
To many onlookers, since the great financial crisis, the world of fixed income securities has become an alien landscape. Yields on government bonds have fallen steadily across all developed markets. As the chart below reveals, there is now a record US$13trln+ of negative yielding fixed income paper, most of it issued by the governments’ of Switzerland, Japan and the Eurozone: –
The percentage of Eurozone government bonds with negative yields is now well above 50% (Eur4.3trln) and more than 35% trades with yields which are more negative than the ECB deposit rate (-0,40%). If one adds in investment grade corporates the total amount of negative yielding bonds rises to Eur5.3trln. Earlier this month, German 10yr Bund yields dipped below the deposit rate for the first time, amid expectations that the ECB will cut rates by another 10 basis points, perhaps as early as September.
The idea that one should make a long-term investment in an asset which will, cumulatively, return less at the end of the investment period, seems nonsensical, except in a deflationary environment. With most central banks committed to an inflation target of around 2%, the Chinese proverb, ‘we live in interesting times,’ springs to mind, yet, negative yielding government bonds are now ‘normal times’ whilst, to the normal fixed income investor, they are anything but interesting. As Keynes famously observed, ‘Markets can remain irrational longer than I can remain solvent.’ Do not fight this trend, yields will probably turn more negative, especially if the ECB cuts rates and a global recession arrives regardless.
Today, government and investment grade corporate debt has been joined by a baker’s dozen of short-dated high yield Euro names. This article from IFR – ‘High-yield’ bonds turn negative – explains: –
About 2% of the euro high-yield universe is now negative yielding, according to Bank of America Merrill Lynch.
That percentage would rise to 10% if average yields fall by a further 35bp, said Barnaby Martin, European credit strategist at the bank.
He said the first signs of negative yielding high-yield bonds emerged about two weeks ago in the wake of Mario Draghi’s speech in Sintra where the ECB president hinted at a further dose of bond buying via the central bank’s corporate sector purchase programme. There are now more than 10 high-yield bonds in negative territory…
The move to negative yields for European high-yield credits is unprecedented; it didn’t even happen in 2016 when the ECB began its bond buying programme.
During Q4, 2018, credit spreads widened (and stock markets declined) amid expectations of further Federal Reserve tightening and an end to ECB QE. Now, stoked by fears of a global recession, rate expectation have reversed. The Fed are likely to ease, perhaps as early as this month. The ECB, under their new broom, Christine Lagarde, is expected to embrace further QE. The corporate sector purchase program (CSPP) which commenced in June 2016, already holds Eur177.8bln of corporate bonds, but increased corporate purchases seem likely; it is estimated that the ECB holds between 25% and 30% of the outstanding Eurozone government bond in issue, near to its self-imposed ceiling of 33%. Whilst the amount in issues is less, the central bank has more flexibility with Supranational and Euro denominated non-EZ Sovereigns (50%) and greater still with corporates (70%). In this benign interest rate environment, a continued compression of credit spreads is to be expected.
Yield compression has been evident in Eurozone government bonds for decades, but now a change in relationship is starting become evident. Even if the ECB does not increase the range of corporate bonds it purchases, its influence, like the rising tide, will float all ships. Bund yields are likely to remain most negative and the government obligations of Greece, the least, but, somewhere between these two poles, corporate bonds will begin to assume the mantle of the ‘nearly risk-free.’ With many Euro denominated high-yield issues trading below the yield offered for comparable maturity Italian BTPs, certain high-yield corporate credit is a de facto alternative to poorer quality government paper.
The chart below is a snap-shot of the 3m to 3yr Eurozone yield curve. The solid blue line shows the yield of AAA rated bonds, the dotted line, an average of all bonds: –
It is interesting to note that the yield on AAA bonds, with a maturity of less than two years, steadily becomes less negative, whilst the aggregated yield of all bonds continues to decline.
The broader high-yield market still offers positive yield but the Eurozone is likely to be the domicile of choice for new issuers, since Euro high-yield now trades at increasingly lower yields than the more liquid US market, the liquidity tail is wagging the dog: –
Source: Bloomberg, Barclays
The yield compression within the Eurozone has been more dramatic but it has been mirrored by the US where the spread between BBB and BB narrowed to a 12 year low of 60 basis points this month.
Wither away the dealers?
Forgotten, amid the inexorable bond rally, is dealer liquidity, yet it is essential, especially when investors rush for the exit simultaneously. For corporate bond market-makers and brokers the impact of QE has been painful. If the ECB is a buyer of a bond (and they pre-announce their intentions) then the market is guaranteed to rise. Liquidity is stifled in a game of devil take the hindmost. Alas, non-eligible issues, which the ECB does not deign to buy, find few natural buyers, so few institutions can justify purchases when credit default risk remains under-priced and in many cases the yield to maturity is negative.
An additional deterrent is the cost of holding an inventory of fixed income securities. Capital requirements for other than AAA government paper have increased since 2009. More damaging still is the negative carry across a wide range of instruments. In this environment, liquidity is bound to be impaired. The danger is that the underlying integrity of fixed income markets has been permanently impaired, without effective price intermediation there is limited price discovery: and without price discovery there is a real danger that there will be no firm, ‘dealable’ prices when they are needed most.
In this article from Bloomberg – A Lehman Survivor Is Prepping for the Next Credit Downturn – the interviewee, Pilar Gomez-Bravo of MFS Investment Management, discusses the problem of default risk in terms of terms of opacity (the emphasis is mine): –
Over a third of private high-yield companies in Europe, for example, restrict access to financial data in some way, according to Bloomberg analysis earlier this year. Buyers should receive extra compensation for firms that curb access to earnings with password-protected sites, according to Gomez-Bravo.
Borrowers still have the upper hand in the U.S. and Europe. Thank cheap-money policies and low defaults. Speculation the European Central Bank is preparing for another round of quantitative easing is spurring the rally — and masking fragile balance sheets.
Borrowers still have the upper hand indeed, earlier this month Italy issued a Eur3bln tranche of its 2.8% coupon 50yr BTP; there were Eur17bln of bids from around 200 institutions (bid/cover 5.66, yield 2.877%). German institutions bought 35% of the issue, UK investors 22%. The high bid/cover ratio is not that surprising, only 1% of Euro denominated investment grade paper yields more than 2%.
I am not alone in worrying about the integrity of the bond markets in the event of another crisis, last September ESMA – Liquidity in EU fixed income markets – Risk indicators and EU evidence concluded: –
Episodes of short-term volatility and liquidity stress across several markets over the past few years have increased concerns about the worsening of secondary market liquidity, in particular in the fixed income segment…
…our findings show that market liquidity has been relatively ample in the sovereign segment, potentially also due to the effects of supportive economic policies over more recent years. This is different from our findings in the corporate bond market, where in recent years we did not find systematic and significant drop in market liquidity but we observed episodes of decreasing market liquidity when market conditions deteriorated…
We find that in the sovereign bond segment, bonds that have a benchmark status and are characterised by larger outstanding amounts tend to be more liquid while market volatility is negatively related to market liquidity. Outstanding amounts are the main bond-level drivers in the corporate bond segment…
With reference to corporate bond markets, the sensitivity of bond liquidity to bond-specific and market factors is larger when financial markets are under stress. In particular, bonds characterised by more volatile market liquidity are found to be more vulnerable in periods of market stress. This empirical result is consistent with the market liquidity indicators developed for corporate bonds pointing at episodes of decreasing market liquidity when wider market conditions deteriorate.
ESMA steer clear of discussing negative yields and their impact on the profitability of market-making, but the BIS annual economic report, published last month, has no such qualms (the emphasis is mine): –
Household debt has reached new historical peaks in a number of economies that were not at the heart of the GFC, and house price growth has in many cases stalled. For a group of advanced small open economies, average household debt amounted to 101% of GDP in late 2018, over 20 percentage points above the pre-crisis level… Moreover, household debt service ratios, capturing households’ principal and interest payments in relation to income, remained above historical averages despite very low interest rates…
…corporate leverage remained close to historical highs in many regions. In the United States in particular, the ratio of debt to earnings in listed firms was above the previous peak in the early 2000s. Leverage in emerging Asia was still higher, albeit below the level immediately preceding the 1990s crisis. Lending to leveraged firms – i.e. those borrowing in either high-yield bond or leveraged loan markets – has become sizeable. In 2018, leveraged loan issuance amounted to more than half of global publicly disclosed loan issuance loans excluding credit lines.
… following a long-term decline in credit quality since 2000, the share of issuers with the lowest investment grade rating (including financial firms) has risen from around 14% to 45% in Europe and from 29% to 36% in the United States. Given widespread investment grade mandates, a further drop in ratings during an economic slowdown could lead investors to shed large amounts of bonds quickly. As mutual funds and other institutional investors have increased their holdings of lower-rated debt, mark-to-market losses could result in fire sales and reduce credit availability. The share of bonds with the lowest investment grade rating in investment grade corporate bond mutual fund portfolios has risen, from 22% in Europe and 25% in the United States in 2010 to around 45% in each region.
How financial conditions might respond depends also on how exposed banks are to collateralised loan obligations (CLOs). Banks originate more than half of leveraged loans and hold a significant share of the least risky tranches of CLOs. Of these holdings, US, Japanese and European banks account for around 60%, 30% and 10%, respectively…
…the concentration of exposures in a small number of banks may result in pockets of vulnerability. CLO-related losses could reveal that the search-for-yield environment has led to an underpricing and mismanagement of risks…
In the euro area, the deterioration of the growth outlook was more evident, and so was its adverse impact on an already fragile banking sector. Price-to-book ratios fell further from already depressed levels, reflecting increasing concerns about banks’ health…
Unfortunately, bank profitability has been lacklustre. In fact, as measured, for instance, by return-on-assets, average profitability across banks in a number of advanced economies is substantially lower than in the early 2000s. Within this group, US banks have performed considerably better than those in the euro area, the United Kingdom and Japan…
…persistently low interest rates and low growth reduce profits. Compressed term premia depress banks’ interest rate margins from maturity transformation. Low growth curtails new loans and increases the share of non-performing ones. Therefore, should growth decline and interest rates continue to remain low following the pause in monetary policy normalisation, banks’ profitability could come under further pressure.
Conclusion and investment opportunities
Back in 2006, when commodity investing, as part of a diversified portfolio, was taking the pension fund market by storm, I gave a series of speeches in which I beseeched fund managers to consider carefully before investing in commodities, an asset class which had for more than 150 years exhibited a negative expected real return.
An astonishingly large percentage of fixed income securities are exhibiting similar properties today. My advice, then for commodities and today, for fixed income securities, is this, ‘By all means buy, but remember, this is a trading asset, its long-term expected return is negative; in other words, please, don’t forget to sell.’
Macro Letter – No 117 – 28-06-2019
Interest Rates, Global Value Chains and Bank Reserve Requirements
In a recent speech, Hyun Song Shin, Head of Research at the BIS, discussed – What is behind the recent slowdown? The speech focused on the weakening of global value chains (GVC’s) in manufactured goods. The manufacturing sector is critical, since it accounts for 70% of global merchandise trade: –
During the heyday of globalisation in the late 1980s and 1990s, trade grew at twice the pace of GDP. In turn, trade growth in manufactured goods was driven by the growing importance of multinational firms and the development of GVCs that knit together the production activity of firms around the world.
The chart below reveals the transformation of the world economy over the past 17 years: –
Source: BIS, X Li, B Meng and Z Wang, “Recent patterns of global production and GVC participation”, in D Dollar (ed), Global Value Chain Development Report 2019, World Trade Organization et al.
Hyun’s next chart tracks the sharp reversal in the relationship between world trade and GDP growth as a result of the Great Financial Crisis (GFC): –
Sources: IMF, World Economic Outlook; World Trade Organization; Datastream; national data; BIS calculations
The important point, highlighted by Hyun, is that the retrenchment in trade occurred almost a decade before the trade war began. China, growing at 6% plus, has captured an increasing share of global trade at the expense of the developed nations, most notably the US. Europe went through a similar transition during the second half of the 19th century, as the US transformed from an agrarian to an industrial society.
Returning to the present, supporting GVCs is capital intensive. Historically low interest rates have allowed these chains to flourish, but the recent reversal of interest rate policy by the Federal Reserve has caused structural cracks to emerge in the edifice. The BIS describes the situation for multi-national manufacturing firms in this way (the emphasis is mine): –
…firms enmeshed in global value chains could be compared to jugglers with many balls in the air at the same time. Long and intricate GVCs have many balls in the air, necessitating greater financial resources to knit the production process together. More accommodative financial conditions then act like weaker gravity for the juggler, who can throw many more balls into the air, including large balls that represent intermediate goods with large embedded value. However, when the shadow price of credit rises, the juggler has a more difficult time keeping all the balls in the air at once.
When financial conditions tighten, very long and elaborate GVCs will no longer be viable economically. A rationalisation of supply chains through “on-shoring” and “re-shoring” of activity towards domestic suppliers, or to suppliers that are closer geographically, will help reduce the credit costs of supporting long GVCs.
It is interesting to note the use of the phrase ‘shadow price of credit,’ this suggests that concern about the intermediation process by which changes in the ‘risk-free’ rate disseminate into the real-economy. In a 2014 study, the BIS Committee on the Global Financial System (CGFS) found that 65% of world trade is still financed through ‘open account financing’ or through the buyer paying in advance. For GVC’s, short-term US interest rates matter, especially when 80% of trade finance is still transacted in the US$. Even when rates reached their nadir, banks were reluctant to lend at such favourable terms as they had prior to the GFC. The recent rise in short-term interest rates has supported the US$, accelerating the reversal in the trade to GDP ratio.
A closer investigation of bank lending since the GFC reveals structural weakness in the intermediation process. Since 2009, at the same time as interest rates fell, bank capital requirements rose. The impact of this fiscal offsetting of monetary accommodation can be seen most clearly in the global collapse the velocity of circulation of money supply: –
Source: Tom Drake, National Data, Macrobond
The mechanism by which credit reaches the real economy has been choked. Banks have gradually repaired their balance sheets, but the absurd incentives, such as the inducement to purchase zero risk-weighted government debt rather than lending to corporates, have been given fresh impetus through a combination of structurally higher capital requirements and lower interest rates.
In their January 2018 publication – Structural changes in banking after the crisis – the BIS examines how credit intermediation has changed (the emphasis is mine): –
The crisis revealed substantial weaknesses in the banking system and the prudential framework, which had led to excessive lending and risk-taking unsupported by adequate capital and liquidity buffers…
There is no clear evidence of systematic and long-lasting retrenchment of banks from credit intermediation. The severity of the crisis was not uniform across banks and systems. Weaker banks cut back credit more strongly, and riskier borrowers saw their access to credit more tightly curtailed. In the immediate aftermath of the crisis the response of policymakers and bank managers was also differentiated across systems, with some moving more decisively than others to address the problems revealed. Bank credit has since grown relative to GDP in most jurisdictions, but has not returned to pre-crisis highs in the most affected countries, reflecting necessary deleveraging and the unwinding of pre-crisis excesses. While disentangling demand and supply drivers remains a challenging exercise, the evidence gathered by the Working Group does not point to systematic change in the willingness of banks to lend locally. In line with the objectives of post-crisis reforms, lenders have become more sensitive to risk and more discriminating across borrowers…
The last two sentences appear to contradict, but measuring of loan quality from without is always a challenge. The authors’ continue to perceive credit quality and intermediation, through a glass darkly (once again, the emphasis is mine): –
If anything, the shift towards commercial banking activities suggests that banks are putting more emphasis on lending than trading activities. Still, given the range of changes in the banking sector over the past decade, policymakers should remain attentive to potential unintended “gaps” in credit to the real economy. Legacy asset quality problems can be an obstacle to credit growth. Excessive pre-crisis credit growth left a legacy of problem assets, especially high levels of NPLs, which continue to distort the allocation of fresh credit in several countries…
Persistently high NPLs are likely to lead to greater ultimate losses, impede credit growth and distort credit reallocation, potentially incentivising banks to take on more risk….
Again, the evidence seems to be contradictory. What is different between the cyclical patterns of the past and the current state of affairs? The tried and tested central bank solution to previous crises, stretching all the way back to the 1930’s, if not before, is to cut short-term interest rates – regardless of the level of inflation. The yield curve steepens sharply and banks rapidly repair their balance sheets by borrowing short-term and lending long-term. In the wake of the GFC, however, rates declined yet the economy failed to respond to the stimulus, at least in part, because the central banks accommodative actions were being negated by the tightening of regulatory conditions. Collectively the central banks and the national regulators were robbing Peter to pay Paul. The result (please pardon my emphasis once more): –
Post-crisis bank profitability has remained subdued. This reflects many factors, including bank-specific drivers (eg business model choices), cyclical macroeconomic drivers (eg low growth and interest rates) and structural drivers that will have a more persistent impact. An example of this latter group includes regulatory reforms that have implied lower leverage and the curbing of certain higher risk activities, and a reduction of implicit subsidies for large or systemically important banks…
…all else constant, lower leverage and reduced risk-taking should reduce return on equity. Sluggish revenues have dampened profits and, combined with low interest rates, may have contributed to the slower progress made by some banks in dealing with legacy problem assets…
Sufficient levels of capital are needed for banks to deal with unexpected shocks, and low profitability can weaken banks’ ability to maintain sufficient buffers. Banks that lack a steady stream of earnings to repair their capital base after an unexpected loss will have to rely on fresh equity issuance. Yet, markets are usually an expensive source of capital for banks, when accessed under duress….
In this scenario banks have an incentive to extend and reschedule zombie loans in order to avoid right-downs. Companies which should have been forced into administration linger on, banks’ ability to make new loans is curtailed and new ventures are starved of cash.
The BIS go on to make a number of suggestions in order to deal with low bank profitability and the problem of non-performing legacy assets: –
If overcapacity is a key driver of low profitability, institutional barriers to mergers must be reviewed and exit regimes applied. If the problem lies with legacy assets (such as NPLs), these should be fully addressed, which might entail a dialogue between prudential authorities and other policymakers (eg those in charge of mechanisms dealing with insolvency)…
The exit of financial institutions might be politically costly in the short run, but may pay off in the longer term through more stable banking systems, sounder lending and better allocation of resources. The implicit subsidisation of non-viable business models might have lower short-term costs but could lead to resource misallocation. Similarly, any assessment of consolidation trends needs to take into account potential trade-offs between efficiency and stability, as well as examine the nature and impact of barriers to exit for less profitable banks.
These suggestions make abundant sense but that is no guarantee the BIS recommendations will be heeded.
I am also concerned that the authors’ may be overly optimistic about the resilience of the global banking system: –
Compared with the pre-crisis period, banks are better capitalised and have lower exposure to liquidity and funding risks. They have also reduced activities that contributed to the build-up of vulnerabilities, such as exposure to high-risk assets, and excessive counterparty risk through OTC derivatives and repo transactions, among others. That said, given that markets have not yet evolved through a full financial cycle, bank restructuring efforts remain under way. In addition, as many relevant reforms have not yet been fully implemented, it is too early to assess their full effect.
Thankfully the BIS outlook is not entirely rose-tinted, they do acknowledge: –
…some trends in banking systems that we have observed since the crisis, such as the decline in wholesale funding, might be affected by unconventional monetary policy and may not persist. Success in addressing prior problems does not guarantee that banks will be able to respond to future risks…
Problems of bank governance and risk management contributed to the crisis and have been a key focus of reform. Given that the sources of future vulnerabilities are hard to predict, banks need to have robust frameworks of risk governance and management to identify and understand emerging risks and their potential impacts for the firm.
The BIS choose to gloss over the fact that many banks are still far too big to fail. They avoid discussing whether artificially low interest rates and the excessive flatness of yield curves may be contributing to a different breed of systemic risk. Commercial banks are for-profit institutions, higher capital requirements curtail their ability to achieve acceptable returns on capital. The adoption of central counterparties for the largest fixed income market in the world, interest rate swaps, whilst it reduces the risk for individual banking institutions, increases systemic risk for the market as a whole. The default of a systemically important central counterparties could prove catastrophic.
Conclusions and investment opportunities
The logical solution to the problem of the collapse of global value chains is to create an environment in which the credit cycle fluctuates less violently. A gradual normalisation of interest rates is the first step towards redemption. This could be accompanied by the removal of the moral hazard of central bank and government intervention. The reality? The societal pain of such a gargantuan adjustment would be protracted. It would be political suicide for any democratically elected government to commit to such a meaningful rebalancing. The alternative? More of the same. Come the next crisis central banks will intervene, if they fail to avert disaster, governments’ will resort to the fiscal spigot.
US interest rates will converge towards those of Europe and Japan. Higher stock/earnings multiples will be sustainable, leverage will increase, share buy-backs will continue: and the trend rate of economic growth will decline. Economics maybe the dismal science, but this gloomy economic prognosis will be quite marvellous for assets.
Macro Letter – No 116 – 14-06-2019
Gold – is it all that glisters?
In Q4 2018, as stocks declined, gold rallied 8.1% and gold mining stocks 13.7%. It was a prescient reminder of the value of gold as a portfolio diversifier. There have, however, been some other developments both for gold and gold mining stocks which are worthy of closer investigation.
Central bank net purchases of gold reached 651.5 tons in 2018, up 74% from 2017, when 375 tons were bought. The Russian central bank, perhaps fearing US sanctions, sold almost all of its US Treasury bonds to buy 274.3 tons of gold last year. For probably similar reasons, the Turkish central bank bought 51.5 tons, down from the 88 tons purchased the previous year. Other big central bank buyers included Kazakhstan, India, Iraq, Poland and Hungary.
In the first quarter of 2019 central banks purchased a further 145.5 tons, up 68% on Q1 2018. The trend is not new, central bank purchases have been rising since 2009: –
Source: BIS, IMF, GEMS, Reuters
Putting global reserve holdings in perspective, here is the central bank world ranking as at March 2019: –
Source: IMF, Statistica
Despite the substantial buying from central banks the price of gold has been broadly range bound for the past five years.
Source: Trading Economics
The absence of a sustained rally suggests that many investors have forsaken the barbarous relic, however, concern that the gold price will collapse have to be tempered by the cost of mining an ounce of gold. Mining costs have increased substantially since the early 2000’s due to increasingly expensive exploration costs and a general decline in ore quality. In the chart below Money Metals Exchange shows Barrick (GOLD) and Newmont (NEM) average cost of production since 2000: –
Source: SRSrocco Report, Kitco
In a July 2018 post for Seeking Alpha – Money Metals Exchange – Never Before Seen Charts: Gold Mining Industry’s Costs Are Higher Than Market Realizes show that the amount of ore needed to produce an ounce of gold at Barrick’s (GOLD) Nevada Goldstrike and Cortez Mines has increased four-fold since 1998: –
Source: SRSrocco Report, Barrick
The market capitalisation of the sector has halved since 2012, leading to understandable consolidation and deleveraging. Gold, however, is an unusual commodity in that its stock is far larger than its annual production. About 3000 tons of gold is mined annually, this is dwarfed by the 190,000 tons that have been mined throughout history according to World Gold Council estimates. Since it has little industrial use, almost all the gold ever mined remains in existence: central bank reserves are a key determinant of its price. Interesting research on the subject of what drives gold prices can be found in this article from the London Bullion Market Association – Do Extraction Costs Drive Gold Prices? They conclude that, due to the large stock relative to production, the price of gold is the principal influence on the mining industry.
The US$ and inflation expectations
The rally in the gold price in 2011-2012 was linked to the Eurozone crisis, the moderation since then has coincided with a recovery in the US Dollar Index. Other factors which traditionally drive gold higher include inflation expectations, these fears have continually failed to materialise whilst the inexorable increase in debt has led some to speculate about a debt deflation spiral; an environment in which gold would not be expected to excel: –
Source: Trading Economics
A different approach to gold valuation is the ratio of the gold price to the total-return index for ten-year US government bonds. This ratio has been moving steadily higher, suggesting a shift to an era of structural inflation, according to Gavekal Research. Other evidence of inflation remains muted, however.
Is gold perfectly priced or do the central banks know something we do not?
A look back at the decade after the end of gold reserve standard is a good starting point. The Bretton Woods agreement collapsed in 1971. In the years that followed currency fluctuations were substantial and the US$ lurched steadily lower: –
Source: Trading Economics
The US$ was so little revered that in 1978 the US Treasury had to issue foreign currency denominated Carter Bonds in Swiss Francs and German Marks, such was the level of distrust in the mighty greenback.
Confidence was finally restored when Paul Volker took the helm of the Federal Reserve. Volker did what his predecessor but three, William McChesney Martin, had only talked about – taking away the punch bowl just as the party got started – he hiked interest rates and managed to subdue inflation: the fiat US$ was back in favour.
Today the US$ is undoubtedly the first reserve currency. In the era of digital money and crypto currencies the barbarous relic has stiff competition. Added to which it is traditionally an unexpected inflation hedge and traditionally affords scant protection in a deflationary environment. Given the global overhang of US$ denominated debt, many believe this is the next challenge to the international order.
Considering the conflagration of factors alluded to above, I believe gold is destined to remain a much watched side-line. Gold mining stocks may fare better, as S&P Global Market Intelligence – Outlook 2019: US$3.9B Increase In Earnings For Majors – explains: –
…rising production in 2019, higher metals prices and lower costs could increase free cash flow by US$1.3 billion, or 19%, year over year. Companies will use this increased cash flow to lower net debt, which is expected to fall 19% year over year in 2019, placing the majors at their lowest level of leverage in five years. The majors have been focusing on returns to shareholders. Higher earnings have led to dividend payouts increasing 103% to US$2.0 billion in 2017 from US$1.0 billion in 2016 and remaining at about US$2.0 billion in 2018.
As for price of gold itself? The attractive fundamentals underpinning mining stocks is likely to cap the upside, whilst continued central bank buying will insure the downside is muzzled too. When I have little fundamental conviction I am inclined to follow the trend. A break to the upside maybe closer, but the long period of price consolidation favours a break to the downside in the event of a global crisis.