Oil and Italy were the main themes last month.
Oil and Italy were the main themes last month.
A monthly review of the macro themes and drivers of markets for March 2018
Macro Letter – No 94 – 06-04-2018
What to expect from Central Bankers
As financial markets adjust to a new, higher, level of volatility, it is worth considering what the Central Banks might be thinking longer term. Many commentators have been blaming geopolitical tensions for the recent fall in stocks, but the Central Banks, led by the Fed, have been signalling clearly for some while. The sudden change in the tempo of the stock market must have another root.
Whenever one considers the collective views of Central Banks it behoves one to consider the opinions of the Central Bankers bank, the BIS. In their Q4 review they discuss the paradox of a tightening Federal Reserve and the continued easing in US national financial conditions. BIS Quarterly Review – December 2017 – A paradoxical tightening?:-
Overall, global financial conditions paradoxically eased despite the persistent, if cautious, Fed tightening. Term spreads flattened in the US Treasury market, while other asset markets in the United States and elsewhere were buoyant…
Chicago Fed’s National Financial Conditions Index (NFCI) trended down to a 24-year trough, in line with several other gauges of financial conditions.
The authors go on to observe that the environment is more reminiscent of the mid-2000’s than the tightening cycle of 1994. Writing in December they attribute the lack of market reaction to the improved communications policies of the Federal Reserve – and, for that matter, other Central Banks. These policies of gradualism and predictability may have contributed to, what the BIS perceive to be, a paradoxical easing of monetary conditions despite the reversals of official accommodation and concomitant rise in interest rates.
This time, however, there appears to be a difference in attitude of market participants, which might pose risks later in this cycle:-
…while investors cut back on the margin debt supporting their equity positions in 1994, and stayed put in 2004, margin debt increased significantly over the last year.
At a global level it is worth remembering that whilst the Federal Reserve has ceased QE and now begun to shrink its balance sheet, elsewhere the expansion of Central Bank balance sheets continues with what might once have passed for gusto.
The BIS go on to assess stock market valuations, looking at P/E ratios, CAPE, dividend pay-outs and share buy-backs. By most of these measures stocks look expensive, however, not by all measures:-
Stock market valuations looked far less frothy when compared with bond yields. Over the last 50 years, the real one- and 10-year Treasury yields have fluctuated around the dividend yield. Having fallen close to 1% prior to the dotcom bust, the dividend yield has been steadily increasing since then, currently fluctuating around 2%. Meanwhile, since the GFC, real Treasury yields have fallen to levels much lower than the dividend yield, and indeed have usually been negative. This comparison would suggest that US stock prices were not particularly expensive when compared with Treasuries.
The authors conclude by observing that EM sovereign bonds in local currency are above their long-term average yields. This might support the argument that those stock markets are less vulnerable to a correction – I would be wary of jumping this conclusion, global stocks market correlation may have declined somewhat over the last couple of years but when markets fall hard they fall in tandem: correlations tend towards 100%:-
Source: BIS, BOML, EPFR, JP Morgan
The BIS’s final conclusion?-
In spite of these considerations, bond investors remained sanguine. The MOVE* index suggested that US Treasury volatility was expected to be very low, while the flat swaption skew for the 10-year Treasury note denoted a low demand to hedge higher interest rate risks, even on the eve of the inception of the Fed’s balance sheet normalisation. That may leave investors ill-positioned to face unexpected increases in bond yields.
*MOVE = Merrill lynch Option Volatility Estimate
Had you read this on the day of publication you might have exited stocks before the January rally. As markets continue to vacillate wildly, there is still time to consider the implications.
Another BIS publication, from January, also caught my eye, it was the transcript of a speech by Claudio Borio’s – A blind spot in today’s macroeconomics? His opening remarks set the scene:-
We have got so used to it that we hardly notice it. It is the idea that, for all intents and purposes, when making sense of first-order macroeconomic outcomes we can treat the economy as if its output were a single good produced by a single firm. To be sure, economists have worked hard to accommodate variety in goods and services at various levels of aggregation. Moreover, just to mention two, the distinctions between tradeables and non-tradeables or, in some intellectual strands, between consumption and investment goods have a long and distinguished history. But much of the academic and policy debate among macroeconomists hardly goes beyond that, if at all.
The presumption that, as a first approximation, macroeconomics can treat the economy as if it produced a single good through a single firm has important implications. It implies that aggregate demand shortfalls, economic fluctuations and the longer-term evolution of productivity can be properly understood without reference to intersectoral and intrasectoral developments. That is, it implies that whether an economy produces more of one good rather than another or, indeed, whether one firm is more efficient than another in producing the same good are matters that can be safely ignored when examining macroeconomic outcomes. In other words, issues concerned with resource misallocations do not shed much light on the macroeconomy.
Borio goes on to suggest that ignoring the link between resource misallocations and macroeconomic outcomes is a dangerous blind spot in marcoeconomic thinking. Having touched on the problem of zombie firms he talks of a possible link between interest rates, resource misallocations and productivity.
The speaker reveals two key findings from BIS research; firstly that credit booms tend to undermine productivity growth and second, that the subsequent impact of the labour reallocations that occur during a financial boom last for much longer if a banking crisis follows. Productivity stagnates following a credit cycle bust and it can be protracted:-
Taking, say, a (synthetic) five-year credit boom and five postcrisis years together, the cumulative shortfall in productivity growth would amount to some 6 percentage points. Put differently, for the period 2008–13, we are talking about a loss of some 0.6 percentage points per year for the advanced economies that saw booms and crises. This is roughly equal to their actual average productivity growth during the same window.
Source: Borio et al, BIS
Borio’s conclusion is that different sectors of the economy expand and the contract with greater and lesser momentum, suggesting the need for more research in this area.
He then moves to investigate the interest rate productivity nexus, believing the theory that, over long enough periods, the real economy evolves independently of monetary policy and therefore that market interest rates converge to an equilibrium real interest rates, may be overly simplistic. Instead, Borio suggests that causality runs from interest rates to productivity; in other words, that interest rates during a cyclical boom may have pro-cyclical consequences for certain sectors, property in particular:-
During the expansion phase, low interest rates, especially if persistent, are likely to increase the cycle’s amplitude and length. After all, one way in which monetary policy operates is precisely by boosting credit, asset prices and risk-taking. Indeed, there is plenty of evidence to this effect. Moreover, the impact of low interest rates is unlikely to be uniform across the economy. Sectors naturally differ in their interest rate sensitivity. And so do firms within a given sector, depending on their need for external funds and ability to tap markets. For instance, the firms’ age, size and collateral availability matter. To the extent that low interest rates boost financial booms and induce resource shifts into sectors such as construction or finance, they will also influence the evolution of productivity, especially if a banking crisis follows. Since financial cycles can be quite long – up to 16 to 20 years – and their impact on productivity growth quite persistent, thinking of changes in interest rates (monetary policy) as “neutral” is not helpful over relevant policy horizons.
During the financial contraction, persistently low interest rates can contribute to this outcome (Borio (2014)). To be absolutely clear: low rates following a financial bust are welcome and necessary to stabilise the economy and prevent a downward spiral between the financial system and output. This is what the crisis management phase is all about. The question concerns the possible collateral damage of persistently and unusually low rates thereafter, when the priority is to repair balance sheets in the crisis resolution phase. Granted, low rates lighten borrowers’ heavy debt burden, especially when that debt is at variable rates or can be refinanced at no cost. But they may also slow down the necessary balance sheet repair.
Finally, Borio returns to the impact on zombie companies, whose number has risen as interest rates have fallen. Not only are these companies reducing productivity and economic growth in their own right, they are draining resources from the more productive new economy. If interest rates were set by market forces, zombies would fail and investment would flow to those companies that were inherently more profitable. Inevitably the author qualifies this observation:-
Now, the relationship could be purely coincidental. Possible factors, unrelated to interest rates as such, might help explain the observed relationship. One other possibility is reverse causality: weaker profitability, as productivity and economic activity decline in the aggregate, would tend to induce central banks to ease policy and reduce interest rates.
Source: Banerjee and Hoffmann, BIS
Among the conclusions reached by the Central Bankers bank, is that the full impact and repercussions of persistently low rates may not have been entirely anticipated. An admission that QE has been an experiment, the outcome of which remains unclear.
Conclusions and Investment Opportunities
These two articles give some indication of the thinking of Central Bankers globally. They suggest that the rise in bond yields and subsequent fall in equity markets was anticipated and will be tolerated, perhaps for longer than the market anticipate. It also suggests that Central Banks will attempt to use macro-prudential policies more extensively in future, to insure that speculative investment in the less productive areas of the economy do not crowd out investment in the more productive and productivity enhancing sectors. I see this policy shift taking the shape of credit controls and increases in capital requirements for certain forms of collateralised lending.
Whether notionally independent Central Banks will be able to achieve these aims in the face of pro-cyclical political pressure remains to be seen. A protracted period of readjustment is likely. A stock market crash will be met with liquidity and short term respite but the world’s leading Central Banks need to shrink their balance sheets and normalise interest rates. We have a long way to go. Well managed profitable companies, especially if they are not saddled with debt, will still provide opportunities, but stock indices may be on a sideways trajectory for several years while bond yields follow the direction of their respective Central Banks official rates.
Macro Letter – No 93 – 23-03-2018
Stocks for the Long Run but not the short
The first part of the title of this Macro Letter is borrowed from an excellent book originally written in 1994. Among several observations made by the author, Jeremy Siegel, was the idea that stocks would at least keep pace with GDP growth or even exceed it at the national level. The data, which went back to the 19th Century, showed that stocks also outperformed bonds in the long-run. The price one has to pay for that outperformance is higher volatility than for bonds and occasional, possibly protracted, periods of under-performance or, if your portfolio is concentrated, the risk of default. This is not to say that bonds are exempt from default risk, notwithstanding the term ‘risk free rate’ which we associate with many government obligations. A diversified portfolio of stocks (and bonds) has been seen as the ideal investment approach ever since Markowitz promulgated the concept of modern portfolio theory.
Today, passive index tracking funds have swallowed a massive percentage of all the investment which flows into the stock market. Why? Because robust empirical data shows that it is almost impossible for active portfolio managers to consistently outperform their benchmark index in the long run once their higher fees have been factored in.
An interesting way of showing how indexation has propelled the stock market higher recently, regardless of valuation, is shown in this chart from Ben Hunt at Epsilon Theory – Three Body Problem. He uses it to show how the factor which is QE has trumped everything in its wake. I’ll allow Ben to explain:-
Here’s the impact of all that gravity on the Quality-of-Companies derivative investment strategy.
The green line below is the S&P 500 index. The white line below is a Quality Index sponsored by Deutsche Bank. They look at 1,000 global large cap companies and evaluate them for return on equity, return on invested capital, and accounting accruals … quantifiable proxies for the most common ways that investors think about quality. Because the goal is to isolate the Quality factor, the index is long in equal amounts the top 20% of measured companies and short the bottom 20% (so market neutral), and has equal amounts invested long and short in the component sectors of the market (so sector neutral). The chart begins on March 9, 2009, when the Fed launched its first QE program.
Source: Bloomberg, Deutsche Bank
Over the past eight and a half years, Quality has been absolutely useless as an investment derivative. You’ve made a grand total of not quite 3% on your investment, while the S&P 500 is up almost 300%.
Long term there are two strategies which have been shown to consistently improve risk adjusted return from the stock market, momentum (by which I mean trend following) and value (I refer you to Graham and Dodd). Last month the Managed Futures community, consisting primarily of momentum based strategies, had its worst month for 17 years. Value, as the chart above declares, has been out of favour since the great recession at the very least. Indiscriminate Momentum has been the star performer over the same period. The chart below uses a log scale and is adjusted for inflation:-
Source: Advisor Perspectives
At the current level we are certainly sucking on ether in terms of the variance from trend. If the driver has been QE and QQE then the experiment have been unprecedented; a policy mistake is almost inevitable, as Central Banks endeavour to unwind their egregious largesse.
My good friend, and a former head of bond trading at Bankers Trust, wrote a recent essay on the subject of Federal Reserve policy in the new monetary era. He has kindly consented to allow me to quote some of his poignant observations, he starts by zooming out – the emphasis is mine:-
Recent debates regarding future monetary policy seem to focus on a degree of micro-economic precision no longer reliably available from the monthly data. Arguments about minor changes in the yield curve or how many tightening moves will occur this year risk ignoring the dramatic adjustments in all major economic policies of the United States, not to mention the plausible array of international responses…
…for the first time since the demise of Bear Stearns, et al; global sovereign bond markets will have to seek out a new assemblage of price-sensitive buyers…
Given that QE was a systematic purchase programme devoid of any judgement about relative or absolute value, the return of the price-sensitive buyer, is an important distinction. The author goes on to question how one can hope to model the current policy mix.
…There is no confident means of modeling the interaction of residual QE, tax reform, fiscal pump-priming, and now aggressive tariffs. This Mnuchin concoction is designed to generate growth exceeding 3%. If successful, the Fed’s inflation goal will finally be breached in a meaningful way…
…Classical economists will argue that higher global tariffs are contractionary; threatening the recession that boosts adrenaline levels among the passionate yield curve flattening crowd. But they are also inflationary as they reduce global productivity and bolster input prices…
Contractionary and inflationary, in other words stagflationary. I wonder whether the current bevvy of dovish central bankers will ever switch their focus to price stability at the risk of destroying growth – and the inevitable collapsed in employment that would signify?
Hot on the heels of Wednesday’s rate hike, the author (who wrote the essay last week) goes on to discuss the market fixation with 25bp rate increases – an adage from my early days in the market was, ‘Rates go up by the lift and down by the stairs,’ there is no reason why the Fed shouldn’t be more pre-emptive, except for the damage it might do to their reputation if catastrophe (read recession) ensues. A glance at the 30yr T-Bond chart shows 3.25% as a level of critical support. Pointing to the dwindling of foreign currency reserves of other central banks as the effect of tariffs reduces their trade surplus with the US, not to mention the deficit funding needs of the current administration, Allan concludes:-
…Powell will hopefully resort to his own roots as a pragmatic investment banker rather than try to retool Yellenism. He will have to be very creative to avoid abrupt shifts in liquidity preference. I strongly advise a very open mind on Powell monetary policy. From current levels, a substantial steepening of the yield curve is far more likely than material flattening, as all fiscal indicators point toward market-led higher bond yields.
What we witnessed in the stock market during February was a wake-up call. QE is being reversed in the US and what went up – stocks, bonds and real estate – is bound to come back down. Over the next decade it is unlikely that stocks can deliver the capital appreciation we have witnessed during the previous 10 years.
Whilst global stock market correlations have declined of late they remain high (see the chart below) the value based approach – which, as the Deutsche Bank index shows, has underwhelmed consistently for the past decade – may now offer a defensive alternative to exiting the stock market completely. This does not have to be Long/Short or Equity Market Neutral. One can still find good stocks even when overall market sentiment is dire.
Source: Charles Schwab, Factset
For momentum investors the first problem with stocks is their relatively high correlation. A momentum based strategy may help if there is a dramatic sell-off, but if the markets move sideways, these strategies are liable to haemorrhage via a steady sequence of false signals, selling at the nadir of the trading range and buying at the zenith, as the overall market moves listlessly sideways. Value strategies generally fare better in this environment by purchasing the undervalued and selling the overvalued.
The table below from Star Capital assesses stock indices using a range of metrics, it is sorted by the 10yr CAPE ratio:-
Source: Star Capital
Of course there are weaknesses in using these methodologies even at the index level. The valuation methods applied by Obermatt in the table below may be of greater benefit to the value oriented investor. These are there Top 10 stocks from the S&P500 index by value, they also assess each stock on the basis of growth and safety, creating a composite ‘combined’ evaluation:-
I was asked this week, why I am still not bearish on the stock market? The simple answer is because the market has yet to turn. ‘The market can remain irrational longer than I can remain solvent,’ is one of Keynes more enduring observations. Fundamental valuations suggest that stocks will underperform over the next decade because they are expensive today. This implies that a bear market may be nigh, but it does not guarantee it. Using a very long-term moving average one might not have exited the stock market since the 1980’s, every bear-market since then has been a mere corrective wave.
The amount of political capital tied up in the stock market is unparalleled. In a world or QE, fiat currencies, budget deficits and big government, it seems foolhardy to bite the hand which feeds. Stocks may well suffer from a sharp and substantial correction. Even if they don’t plummet like a stone they are likely to deliver underwhelming returns over the next decade, but I still believe they offer the best value in the long run. A tactical reduction in exposure may be warranted but be prepared to wait for a protracted period gaining little or nothing from your cash. Diversify into other asset classes but remember the degree to which the level of interest rates and liquidity may influence their prices. Unfashionable value investing remains a tempting alternative.
Linear Talk Macro Roundup for February
Macro Letter – No 91 – 16-02-2018
A safe place to hide – inflation and the bond markets
I used to think if there was reincarnation, I wanted to come back as the president or the pope or a .400 baseball hitter. But now I want to come back as the bond market. You can intimidate everybody – James Carville 1993
Back in the May 1981 US official interest rates hit 20% for the third time in 14 months, the yield on US 10yr Treasury Bond yields lagged somewhat and only reached their zenith in September of that year, at 15.82%. In those days the 30yr Bond was the global bellwether for fixed income securities; its yield high was only 15.20%, the US yield curve was inverted and America languished in the depths of a deep recession.
More than a decade later in 1993 James Carville, then advisor to President Bill Clinton, was still in awe of the power of the bond market. But is that still the case today? Back then, inflation was the genie which had escaped from the bottle with the demise of the Bretton Woods agreement. Meanwhile, Paul Volker, then Chairman of the Federal Reserve was putting into practice what William McChesney Martin, one of his predecessors, had only talked about, namely taking away the punch bowl. Here, for those who are unfamiliar with the speech, is an extract; it was delivered, by Martin, to the New York Bankers Association on 19th October 1955:-
If we fail to apply the brakes sufficiently and in time, of course, we shall go over the cliff. If businessmen, bankers, your contemporaries in the business and financial world, stay on the sidelines, concerned only with making profits, letting the Government bear all of the responsibility and the burden of guidance of the economy, we shall surely fail. … In the field of monetary and credit policy, precautionary action to prevent inflationary excesses is bound to have some onerous effects–if it did not it would be ineffective and futile. Those who have the task of making such policy don’t expect you to applaud. The Federal Reserve, as one writer put it, after the recent increase in the discount rate, is in the position of the chaperone who has ordered the punch bowl removed just when the party was really warming up.
Back in the October 1955 the Discount rate was 2.30% and the 10yr yield was 2.88%. The economy had just emerged from a recession and would not embark on its next downturn until mid-1957.
Today the US yield curve is also unusually flat, especially by comparison with the inflationary era of the 1970’s, 1980’s and 1990’s. In some ways, however, (barring the inflationary blip in 1951-52) it looks similar to the 1950’s. Here is a chart showing the 10yr yield (blue – LHS) and US inflation (dotted – RHS):-
Source: Trading Economics
I believe that in order to protect the asset markets (by which I mean, principally, stocks and real estate) the Federal Reserve (charged as it is with the twin, but not mutually exclusive, objectives of full-employment and stable prices) may decide to focus on economic growth and domestic harmony at the expense of a modicum of, above target, inflation. When Fed Chairman, Martin, talked of removing the punch bowl back in 1955, inflation had already subsided from nearly 10% – mild deflation was actually working its way through the US economy.
Central Bank balance sheets
Today there are several profound differences with the 1950’s, not least, the percentage of the US bond market which is held by Central Banks. As the chart below shows, Central Banks balance sheet expansion continues, at least, at the global level: it now stands at $14.6trn:-
Source: Haver Analytics, Yardeni Research
Like the Fed, the BoJ and ECB have been purchasing their own obligations, by contrast the PBoC’s modus operandi is rather different. The largest holders of US public debt (principally T-Bonds and T-Bills) are foreign institutions. Here is the breakdown as at the end of 2016:-
Source: US Treasury
As of November 2017 China has the largest holding of US debt – US$1.2trn (a combination of the PBoC and state owned enterprises), followed by Japan -US$1.1trn, made up of both private and public pension fund investments. It is not in the interests of China or Japan to allow a collapse in the US bond market, nor is it in the interests of the US government; their ability borrow at historically low yields during the last few years has not encouraged the national debt to decline, nor the budget to balance.
Bond Markets in Europe and Japan
The BoJ continues its policy of yield curve control – targeting a 10bp yield on 10yr JGBs. Its balance sheet now stands at US$4.8trn, slightly behind the ECB and PBoC which are vying for supremacy mustering US$5.5trn apiece. Thanks to the persistence of the BoJ, JGB yields have remained between zero and 10bp since November 2016. As of December 2017 the BoJ owned 46.2% of the total issuance. The ECB, by contrast, holds a mere 19.2% of Eurozone debt.
Another feature of the Eurozone bond market, during the last couple of years, has been the continued convergence in yields between the core and periphery. The chart below shows the evolution of the yield of 10yr Greek Government Bonds (LHS) and German Bunds (RHS). The spread is now at almost its lowest level ever. This may be a reflection of the improved performance of the Greek economy but it is more likely to be driven by fixed income investors continued quest for yield:-
Source: Trading Economics
By contrast with Greece (where yields have fallen) and Germany (where they are on the rise) 10yr Italian BTPs and Spanish Bonos have remained broadly unchanged, whilst French OATs have seen yields rise in sympathy with Germany. Hopes of a Eurobond backed by the EU, to replace the obligations of peripheral nation states, whilst vehemently denied in official circles, appears to remain high.
Japanese and European economic growth, which has surprised on the upside over the past year, needs to prove itself more than purely cyclical. Both regions are reliant on the relative strength of US the economic recovery, together with the continued structural expansion of China and India. The jury is out on whether either Japan or the EU can achieve economic terminal velocity without strong export markets for their goods and services.
The one country in the European area which is behaving differently is the UK; yields have risen but, it stands apart from the rest of the Eurozone; UK Gilts dance to a different tune. Uncertainty about Brexit caused Sterling to decline, especially against the Euro, import prices rose in response, pushing inflation higher. 10yr Gilt yields bottomed in August 2016 at 50bp. Since then they have risen to 1.64% – this is still some distance from the highs of January 2014 when they tested 3.09%. 2yr Gilts are different matter, with a current yield of 71bp they are 63bp from their lows but just 22bp away from the 2014 high of 93bp.
Conclusions and Investment Opportunities
From a personal investment perspective, I have been out of the bond markets since 2013. My reasoning (which proved expensive) was that the real-yields on the majority of markets was already extremely negative and the notional yields were uncomfortably close to zero. Of course these markets went much, much further than I had anticipated. Now I am tempted by the idea of reallocating, despite yields being lower than they were when I exited previously. Inflation in the US is 2.1%, in the Euro Area it is 1.3% whilst in Japan it is still just 1%.
As a defensive investment one should look for short duration bonds, but in the US this brings the investor into conflict with the hawkish policy stance of the Fed; that is, what my friend Ben Hunt of Epsilon Theory dubs, the Inflation Narrative. For a contrary view this Kansas City Fed paper may be of interest – Has the Anchoring of Inflation Expectations Changed in the United States during the Past Decade?
In Japan yields are still too near the zero bound to be enticing. In Germany you need to need to go all the way out to 6yr maturity Bunds before you receive a positive yield. There is an alternative to consider – 2yr Gilts:-
Source: Trading Economics
UK inflation is running at 3% – that puts it well above the BoE target of 2%. Rate increases are anticipated. 2yr Gilt yields have recently followed the course steered by the US and Germany, taking out the highs last seen in December 2015, however, if (although I really mean when) a substantial stock market correction occurs, 2yr Gilt yields have the attraction of being near the top of their five year range – unlike 2yr Schatz which are nearer the bottom of theirs. 2yr Gilts will benefit from a slowdown in Europe and any uncertainty surrounding Brexit. The BoE will be caught between the need to quell inflation and the needs of the economy as a whole. 2yr Gilts also offer the best roll-down on the UK yield curve. The 1yr maturity yields 49bp, whilst the 3yr yields 83bp.
With inflation fears are on the rise, especially in the US and UK, 2yr Gilts make for an uncomfortable investment today, however, they are a serious contender as a safe place to hide, come the real stock market correction.