Debasing the Baseless – Modern Monetary Theory

Debasing the Baseless – Modern Monetary Theory

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Macro Letter – No 114 – 10-05-2019

Debasing the Baseless – Modern Monetary Theory

  • Populist politicians are turning to Modern Monetary Theory
  • Fiscal stimulus has not led to significant inflation during the last decade
  • MMT is too radical to be adopted in full but the allure of fiscal expansion is great
  • Asset markets will benefit over the medium-term

A recent post from the Peterson Institute – Further Thinking on the Costs and Benefits of Deficits – follows on from the Presidential Lecture given by Olivier Blanchard at the annual gathering of the American Economic Association (AEA) Public Debt and Low Interest Rates . The article discusses a number of issues which are linked to Blanchard’s speech: –

  1. Is the political system so biased towards deficit increases that economists have a responsibility to overemphasize the cost of deficits?

  2. Do the changing economics of deficits mean that anything goes and we do not need to pay attention to fiscal constraints, as some have inferred from modern monetary theory (MMT)?

  3. You advocate doing no harm, but is that enough to stabilize the debt at a reasonable level?

  4. Isn’t action on the deficit urgent in order to reduce the risk of a fiscal crisis?

  5. Do you think anything about fiscal policy is urgent?

Their answers are 1. Sometimes, although they question whether it is the role of economists to lean against the political wind. 2. No, which is a relief to those of a more puritanical disposition towards debt. The authors’ argument, however, omits any discussion of the function of interest rates in an unfettered market, to act as a signal about the merit of an investment. When interest rates are manipulated, malinvestment flourishes. They propose: –

…that the political system should adopt a “do no harm” approach, paying for new proposals but not necessarily making it an urgent priority to do any more than that. Adopting this principle would have the benefit of requiring policymakers to think harder about whether to adopt the next seemingly popular tax credit or spending program. Many ideas that seem appealing judged against an unspecified future cost are less appealing when you make their costs explicit today.

  1. Yes. At this point the authors’ make the case for addressing the shortfalls in the social security and health budgets. They make the admirable suggestion that better provision is not only necessary but desirable, however, to achieve their goal they warn more will need to be contributed by individuals. Sadly, I expect politicians to cherry pick from the Modern Monetary Theory (MMT) menu, they will not champion the case for higher individual contributions. 4. No. Here I am in begrudging agreement with their conclusion, although I worry about their projections. Fiat currencies and artificially low interest rates underpin the current political system. It is hardly surprising that developed country government activity, as a share of GDP, has risen. 5. Yes. Again, I agree with the need to think about fiscal policy, though I anticipate that Peterson’s proposals are likely to exacerbate the current problems further.

A prelude to MMT

The reason for highlighting recent Peterson commentary is because it represents the acceptable face of a more dubious set of proposals, known collectively as MMT. These ideas are not particularly modern, beginning with the Chartalist tenet that countries which issue their own fiat currencies can never “run out of money.” For a measured introduction to this topic, Dylan Matthews has published a brilliant essay for Vox – Modern Monetary Theory, explained. Here are some of the highlights: –

[The starting point is]…endogenous money theory, that rejects the idea that there’s a supply of loanable funds out there that private businesses and governments compete over. Instead, they believe that loans by banks themselves create money in accordance with market demands for money, meaning there isn’t a firm trade-off between loaning to governments and loaning to businesses of a kind that forces interest rates to rise when governments borrow too much.

MMTers go beyond endogenous money theory, however, and argue that government should never have to default so long as it’s sovereign in its currency: that is, so long as it issues and controls the kind of money it taxes and spends. The US government, for instance, can’t go bankrupt because that would mean it ran out of dollars to pay creditors; but it can’t run out of dollars, because it is the only agency allowed to create dollars. It would be like a bowling alley running out of points to give players.

A consequence of this view, and of MMTers’ understanding of how the mechanics of government taxing and spending work, is that taxes and bonds do not and indeed cannot directly pay for spending. Instead, the government creates money whenever it spends…

And why does the government issue bonds? According to MMT, government-issued bonds aren’t strictly necessary. The US government could, instead of issuing $1 in Treasury bonds for every $1 in deficit spending, just create the money directly without issuing bonds.

The Mitchell/Wray/Watts MMT textbook argues that the purpose of these bond issuances is to prevent interest rates in the private economy from falling too low. When the government spends, they argue, that adds more money to private bank accounts and increases the amount of “reserves” (cash the bank has stocked away, not lent out) in the banking system. The reserves earn a very low interest rate, pushing down interest rates overall. If the Fed wants higher interest rates, it will sell Treasury bonds to banks. Those Treasury bonds earn higher interest than the reserves, pushing overall interest rates higher…

“In the long term,” they conclude, “the only sustainable position is for the private domestic sector to be in surplus.” As long as the US runs a current account deficit with other countries, that means the government budget has to be in deficit. It isn’t “crowding out” investment in the private sector, but enabling it.

The second (and more profound) aspect of MMT is that it proposes to reverse the roles of fiscal and monetary policy. Taxation is used to control aggregate demand (and thus inflation) whilst government spending (printing money) is used to prevent deflation and to stimulate consumption and employment. Since MMT advocates believe there is no need for bond issuance and that interest rates should reside, permanently, at zero, monetary policy can be controlled entirely by the treasury, making central banks superfluous.

At the heart of MMT is an accounting tautology, that: –

G − T = S – I

Where G = Government spending, T = Taxation, S = Savings and I = Investment

In other words…

Government Budget Deficit = Net Private Saving

wraybook

You may be getting the feeling that something does not quite tally. Robert Murphy of the Mises Institute – The Upside-Down World of MMT explains it like this (the emphasis is mine): –

When I first encountered such a claim — that the government budget deficit was necessary to allow for even the mathematical possibility of net private-sector saving — I knew something was fishy. For example, in my introductory textbook I devote Chapter 4 to “Robinson Crusoe” economics.

To explain the importance of saving and investment in a barter economy, I walk through a simple numerical example where Crusoe can gather ten coconuts per day with his bare hands. This is his “real income.” But to get ahead in life, Crusoe needs to save — to live below his means. Thus, for 25 days in a row, Crusoe gathers his ten coconuts per day as usual, but only eats eight of them. This allows him to accumulate a stockpile of 50 coconuts, which can serve as a ten-day buffer (on half-rations) should Crusoe become sick or injured.

Crusoe can do even better. He takes two days off from climbing trees and gathering coconuts (with his bare hands), in order to collect sticks and vines. Then he uses these natural resources to create a long pole that will greatly augment his labor in the future in terms of coconuts gathered per hour. This investment in the capital good was only possible because of Crusoe’s prior saving; he wouldn’t have been able to last two days without eating had he not been able to draw down on his stockpile of 50 coconuts.

This is an admittedly simple story, but it gets across the basic concepts of income, consumption, saving, investment, and economic growth. Now in this tale, I never had to posit a government running a budget deficit to make the story “work.” Crusoe is able to truly live below his means — to consume less than his income — and thereby channel resources into the production of more capital goods. This augments his future productivity, leading to a higher income (and hence consumption) in the future. There is no trick here, and Crusoe’s saving is indeed “net” in the sense that it is not counterbalanced by a consumption loan taken out by his neighbor Friday…

When MMTers speak of “net saving,” they don’t mean that people collectively save more than people collectively borrow. No, they mean people collectively save more than people collectively invest.

MMT goes on to solve the problem of achieving full employment by introducing a job guarantee and wage controls.

If, by this stage, you feel the need for an antidote to MMT, look no further than, Forty Centuries of Wage and Price Controls: How Not to Fight Inflation by Dr Eamon Butler of the ASI. Published in 1978, it documents the success of these types of policy during the past four thousand years.

Conclusion and Investment Opportunities

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.

John Mauldin describes the end-game of the debt-explosion as the Great Reset, but if government borrowing costs are zero (or lower) the Great Reset can be postponed, but the economy will suffer from low productivity growth due to malinvestment.

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Global Real Estate – Has the tide begun to recede?

Global Real Estate – Has the tide begun to recede?

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Macro Letter – No 113 – 19-04-2019

Global Real Estate – Has the tide begun to recede?

  • Despite the fourth quarter shakeout in stocks, real estate values keep rising
  • Financial conditions remain key, especially in a low rate environment
  • Isolated instances of weakness have yet to breed contagion
  • The reversal of central bank tightening has averted a more widespread correction

I last wrote about the prospects for global real estate back in February 2018 in Macro Letter – No 90 – A warning knell from the housing market – inciting a riot? I concluded: –

The residential real estate market often reacts to a fall in the stock market with a lag. As commentators put it, ‘Main Street plays catch up with Wall Street.’ The Central Bank experiment with QE, however, makes housing more susceptible to, even, a small rise in interest rates. The price of Australian residential real estate is weakening but its commodity rich cousin, Canada, saw major cities price increases of 9.69% y/y in Q3 2017. The US market also remains buoyant, the S&P/Case-Shiller seasonally-adjusted national home price index rose by 3.83% over the same period: no sign of a Federal Reserve policy mistake so far.

As I said at the beginning of this article, all property investment is ‘local’, nonetheless, Australia, which has not suffered a recession for 26 years, might be a leading indicator. Contagion might seem unlikely, but it could incite a riot of risk-off sentiment to ripple around the globe.

More than a year later, central bank interest rates seem to have peaked (if indeed they increased at all) bond yields in most developed countries are falling again and, another round of QE is hotly anticipated, at the first hint of a global, or even regional, slowdown in growth.

In the midst of this sea-change from tightening to easing, an article from the IMF – Assessing the Risk of the Next Housing Bust – appeared earlier this month, in which the authors remind us that housing construction and related spending account for one sixth of US and European GDP. A boom and subsequent bust in house prices has been responsible for two thirds of recessions during the past few decades, nonetheless, they find that: –

…in most advanced economies in our sample, weighted by GDP, the odds of a big drop in inflation-adjusted house prices were lower at the end of 2017 than 10 years earlier but remained above the historical average. In emerging markets, by contrast, riskiness was higher in 2017 than on the eve of the global financial crisis. Nonetheless, downside risks to house prices remain elevated in more than 25 percent of these advanced economies and reached nearly 40 percent in emerging markets in our study.

The authors see a particular risk emanating from China’s Eastern provinces but overall they expect conditions to remain reasonably benign in the short-term. The January 2019 IMF – Global Housing Watch – presents the situation as at Q2 and Q3 2018: –

housepricesaroundtheworld IMF, BIS, ECB,Federal Reserve, Savills, Sinyl Real Estate

Source: IMF, BIS, Federal Reserve, ECB, Savills, Sinyl, National Data

Hong Kong continues to boom and Ireland to rebound.

They go on to analyse real credit growth: –

creditgrowth IMF, Haver Analytics

Source: IMF, Haver Analytics

Interestingly, for several European countries (including Ireland) credit conditions have been tightening, whilst Hong Kong’s price rises seem to be underpinned by credit growth.

Then the IMF compare house prices to average income: –

pricetoincome IMF, OECD

Source: IMF, OECD

Canada comes to the fore-front but Ireland is close second with New Zealand and Portugal not far behind.

Finally the authors assess House price/Rent ratios: –

pricetorent IMF, OECD

Source: IMF, OECD

Both Canada, Portugal and New Zealand are prominent as is Ireland.

This one year snap-shot disguises some lower term trends. The following chart from the September 2018 – UBS Global Real Estate Bubble Index puts the housing market into long-run perspective.

ubs-bubbles-index

Source: UBS

UBS go on to rank most expensive cities for residential real estate, pointing out that top end housing prices declined in half of the list:-

real-estate-bubbles list UBS

Source: UBS

Over the 12 months to September 2018 UBS note that house prices declined in Milan, Toronto, Zurich, New York, Geneva, London, Sydney and Stockholm. The chart below shows the one year change (light grey bar) and the five year change (dark grey line): –

housing-bubbles-growth-rates 1yr - 5yr change UBS

Source: UBS

Is a global correction coming or is property, as always, local? The answer? Local, but with several local markets still at risk.

The US market is generally robust. According to Peter Coy of Bloomberg – America Isn’t Building Enough New Housing – the effect of the housing collapse during the financial crisis still lingers, added to which zoning rules are exacerbating an already small pool of construction-ready lots. Non-credit factors are also corroborated by a recent Fannie Mae survey of housing lenders which found only 1% blaming tight credit, whilst 48% pointed to lack of supply.

North of the border, in Canada, the outlook has become less favourable, partly due to official intervention which began in 2017. Since 2012, house price increases in Toronto accelerated away from other cities, Vancouver followed with a late rush after 2015 and price increases only stalled in the last year.

In their February 2019 report Moody Analytics – 2019 Canada Housing Market Outlook: Slower, Steadier – identify the risks as follows: –

Interventions by the BoC, OSFI, and the British Columbia and Ontario governments were by no means a capricious attempt to deflate a house price bubble for the mere sake of deflation. Financial and macroeconomic aggregates point to the possibility that the mortgage credit needed to sustain house price appreciation may be unsustainable. Since 2002, the ratio of mortgage debt service payments to disposable income has gone from a historical low point of little more than 5% in 2003 to almost 6.6% by the end of last year…

The authors go on to highlight the danger of the overall debt burden, should interest rates rise, or should the Canadian economy slow, as it is expected to do next year. They expect the ratio of household interest payments to disposable income to rise and the percentage of mortgage arrears to follow a similar trajectory. In reality the rate of arrears is still forecast to reach only 0.3%, significantly below its historical average.

External factors could create the conditions for a protracted slump in Canadian real estate. Moody’s point to a Chinese real estate crash, a no-deal Brexit, renewed austerity in Europe and a continuation of the US/China trade dispute as potential catalysts. In this scenario 4% of mortgages would be in arrears. For the present, however, Canadian housing prices remain robust.

Switching to China, the CBRE – Greater China Real Estate Market Outlook 2019 – paints a mixed picture of commercial real estate in the year ahead: –

Office: U.S.–China trade conflict and the ensuing economic uncertainty are set to dent office demand in mainland China and Hong Kong. Leasing momentum in Taiwan will be less affected. Office rents will likely soften in oversupplied and trade and manufacturing-driven cities in 2019.

Retail: The amalgamation of online and offline will continue to drive the evolution of retail demand on the mainland. Retailers in Hong Kong and Taiwan will adopt a conservative approach towards expansion due to the diminishing wealth effect. Retail rents are projected to stay flat or grow slightly in most markets across Greater China.

Logistics: Tight land and warehouse supply will translate into steady logistics rental growth in the Greater Bay Area, Yangtze River Delta and Pan-Beijing area. Risks include potential weaker leasing demand stemming from the U.S.-China trade conflict and the gradual migration to self-built warehouses by major e-commerce companies.

The Chinese housing market, by contrast, has suffered from speculative over-supply. Estimates last year suggested that 22% of homes, amounting to around 50 million dwellings, are unoccupied. Government intervention has been evident for several years in an attempt to moderate price fluctuations. Earlier this month the National Development and Reform Commission (NDRC) said it aims to increase China’s urbanization rate by at least 1% with the aim of tackling the surfeit of supply. This is part of a longer-term goal to bring 100 million people into the cities over the five years to 2020. As of last year, 59.6% of China’s population lived in urban areas. According to World Bank data high middle income countries average 65% rising to 82% for high income countries. For China to reach the average high middle income average, another 70mln people need to move from rural to urban regions.

The new NDRC strategy will include the scrapping of restrictions on household registration permits for non-residents in cities of one to three million. For cities of three to five million, restrictions will be “comprehensively relaxed,” although the NDRC did not specify the particulars. Banks will be incentivised to provide credit and the agency also stated that it will support the establishing of real estate investment trusts (REITs) in order to promote a deepening of the residential rental market.

The NDRC action might seem unnecessary, average prices of new homes in the 70 largest Chinese cities rose 10.4% in February, up from 10.0% the previous month. This is the 46th straight monthly price increase and the strongest annual gain since May 2017. Critics point to cheap credit as the principal driver of this trend, they highlight the danger to domestic prices should the government decide to constrain credit growth. The key to maintaining prices is to open the market to foreign capital, this month’s NDRC policy announcement is a gradual step in that direction. It is estimated that at least $50bln of foreign capital will flow China over the next five years.

Despite the booming residential property market, the Chinese government has been tightening credit conditions and cracking down on illegal financial outflows. This has had impacted Australia in particular, investment fell more than 36% to $.8.2bln last year, down from $13bln in 2017. Mining investment fell 90%, while commercial real estate investment declined by 32%, to $3bln from $4.4bln the previous year. Investment in the US and Canada fell even more, declining by 83% and 47% respectively. Globally, however, Chinese investment has continued to grow, rising 4.2%.

Australian residential housing prices, especially in the major cities, have suffered from this downdraft. According to a report, released earlier this month by Core Logic – Falling Property Values Drags Household Wealth Lower – the decline in prices, the worst in more than two decades, is beginning to bite: –

According to the ABS (Australian Bureau of Statistics), total household assets were recorded at a value of $12.6 trillion at the end of 2018. Total household assets have fallen in value over both the September and December 2018 quarters taking household wealth -1.6% lower relative to June 2018. While the value of household assets have fallen by -1.6% over the past two quarters, liabilities have increased by 1.5% over the same period to reach $2.4 trillion. As a result of falling assets and rising liabilities, household net worth was recorded at $10.2 trillion, the lowest it has been since September 2017…

As at December 2018, household debt was 189.6% of disposable income, a record high and up from 188.7% the previous quarter. Housing debt was also a record high 140.2% of disposable income and had risen from 139.5% the previous quarter.

In 2018 the Australian Residential Property Price Index fell 5.1%, worst hit was Sydney, down 7.8% followed by Melbourne, off 6.4%, Darwin, down 3.5% and Perth, which has been in decline since 2015, which shed a further 2.5%. The ABS cited tightening credit conditions and reduced demand from investors and owner occupiers.

According to many commentators, Australian property has been ready to crash since the bursting of the tech bubble but, as this chart shows, prices are rich but not excessive: –

AMP Capital - Australian housing since 1926

Source: AMP Capital

Conclusions and Investment Opportunities

The entire second chapter of the IMF – Global Financial Stability Report – published on 10th April, focusses on housing: –

Large house price declines can adversely affect macroeconomic performance and financial stability, as seen during the global financial crisis of 2008 and other historical episodes. These macro-financial links arise from the many roles housing plays for households, small firms, and financial intermediaries, as a consumption good, long-term investment, store of wealth, and collateral for lending, among others. In this context, the rapid increase in house prices in many countries in recent years has raised some concerns about the possibility of a decline and its potential consequences…

Capital inflows seem to be associated with higher house prices in the short term and more downside risks to house prices in the medium term in advanced economies, which might justify capital flow management measures under some conditions. The aggregate analysis finds that a surge in capital inflows tends to increase downside risks to house prices in advanced economies, but the effects depend on the types of flows and may also be region- or city-specific. At the city level, case studies for Canada, China, and the United States find that flows of foreign direct investment are generally associated with lower future risks, whereas other capital inflows (largely corresponding to banking flows) or portfolio flows amplify downside risks to house prices in several cities or regions. Altogether, when nonresident buyers are a key risk for house prices, contributing to a systemic overvaluation that may subsequently result in higher downside risk, capital flow measures might help when other policy options are limited or timing is crucial. As in the case of macroprudential policies, these measures would not amount to targeting house prices but, instead, would be consistent with a risk management approach to policy. In any case, these conditions need to be assessed on a case-by-case basis, and any reduction in downside risks must be weighed against the direct and indirect benefits of free and unrestricted capital flows, including better smoothing of consumption, diversification of financial risks, and the development of the financial sector.

Aside from some corrections in certain cities (notably Vancouver, Toronto, Sydney and Melboune) prices continue to rise in most regions of the world, spurred on by historically low interest rates and generally benign credit conditions. As I said in last month’s Macro Letter – China in transition – From manufacturer to consumer – China will need to open its borders to foreign investment as its current account switches from surplus to deficit. Foreign capital will flow into Chinese property and, when domestic savings are permitted to exit the country, Chinese capital will support real estate elsewhere. The greatest macroeconomic risk to global housing markets stems from a tightening of financial conditions. Central banks appear determined to lean against the headwinds of a recession. In the long run they may fail but in the near-term the global housing market still looks unlikely to implode.

Central bank balance sheet reductions – will anyone follow the Fed?

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Macro Letter – No 110 – 15-02-2019

Central bank balance sheet reductions – will anyone follow the Fed?

  • The next wave of QE will be different, credit spreads will be controlled
  • The Federal Reserve may continue to tighten but few other CB’s can follow
  • ECB balance sheet reduction might occur if a crisis does not arrive first
  • Interest rates are likely to remain structurally lower than before 2008

The Federal Reserve’s response to the great financial recession of 2008/2009 was swift by comparison with that of the ECB; the BoJ was reticent, too, due to its already extended balance sheet. Now that the other developed economy central banks have fallen into line, the question which dominates markets is, will other central banks have room to reverse QE?

Last month saw the publication of a working paper from the BIS – Risk endogeneity at the lender/investor-of-last-resort – in which the authors investigate the effect of ECB liquidity provision, during the Euro crisis of 2010/2012. They also speculate about the challenge balance sheet reduction poses to systemic risk. Here is an extract from the non-technical summary (the emphasis is mine): –

The Eurosystem’s actions as a large-scale lender- and investor-of-last-resort during the euro area sovereign debt crisis had a first-order impact on the size, composition, and, ultimately, the credit riskiness of its balance sheet. At the time, its policies raised concerns about the central bank taking excessive risks. Particular concern emerged about the materialization of credit risk and its effect on the central bank’s reputation, credibility, independence, and ultimately its ability to steer inflation towards its target of close to but below 2% over the medium term.

Against this background, we ask: Can central bank liquidity provision or asset purchases during a liquidity crisis reduce risk in net terms? This could happen if risk taking in one part of the balance sheet (e.g., more asset purchases) de-risks other balance sheet positions (e.g., the collateralized lending portfolio) by a commensurate or even larger amount. How economically important can such risk spillovers be across policy operations? Were the Eurosystem’s financial buffers at all times sufficiently high to match its portfolio tail risks? Finally, did past operations differ in terms of impact per unit of risk?…

We focus on three main findings. First, we find that (Lender of last resort) LOLR- and (Investor of last resort) IOLR-implied credit risks are usually negatively related in our sample. Taking risk in one part of the central bank’s balance sheet (e.g., the announcement of asset purchases within the Securities Market Programme – SMP) tended to de-risk other positions (e.g., collateralized lending from previous longer-term refinancing operations LTROs). Vice versa, the allotment of two large-scale (very long-term refinancing operations) VLTRO credit operations each decreased the one-year-ahead expected shortfall of the SMP asset portfolio. This negative relationship implies that central bank risks can be nonlinear in exposures. In bad times, increasing size increases risk less than proportionally. Conversely, reducing balance sheet size may not reduce total risk by as much as one would expect by linear scaling. Arguably, the documented risk spillovers call for a measured approach towards reducing balance sheet size after a financial crisis.

Second, some unconventional policy operations did not add risk to the Eurosystem’s balance sheet in net terms. For example, we find that the initial OMT announcement de-risked the Eurosystem’s balance sheet by e41.4 bn in 99% expected shortfall (ES). As another example, we estimate that the allotment of the first VLTRO increased the overall 99% ES, but only marginally so, by e0.8 bn. Total expected loss decreased, by e1.4 bn. We conclude that, in extreme situations, a central bank can de-risk its balance sheet by doing more, in line with Bagehot’s well-known assertion that occasionally “only the brave plan is the safe plan.” Such risk reductions are not guaranteed, however, and counterexamples exist when risk reductions did not occur.

Third, our risk estimates allow us to study past unconventional monetary policies in terms of their ex-post ‘risk efficiency’. Risk efficiency is the notion that a certain amount of expected policy impact should be achieved with a minimum level of additional balance sheet risk. We find that the ECB’s Outright Monetary Transactions – OMT program was particularly risk efficient ex-post since its announcement shifted long-term inflation expectations from deflationary tendencies toward the ECB’s target of close to but below two percent, decreased sovereign benchmark bond yields for stressed euro area countries, while lowering the risk inherent in the central bank’s balance sheet. The first allotment of VLTRO funds appears to have been somewhat more risk-efficient than the second allotment. The SMP, despite its benefits documented elsewhere, does not appear to have been a particularly risk-efficient policy measure.

This BIS research is an important assessment of the effectiveness of ECB QE. Among other things, the authors find that the ‘shock and awe’ effectiveness of the first ‘quantitative treatment’ soon diminished. Liquidity is the methadone of the market, for QE to work in future, a larger and more targeted dose of monetary alchemy will be required.

The paper provides several interesting findings, for example, the Federal Reserve ‘taper-tantrum’ of 2013 and the Swiss National Bank decision to unpeg the Swiss Franc in 2015, did not appear to influence markets inside the Eurozone, once ECB president, Mario Draghi, had made its intensions plain. Nonetheless, the BIS conclude that (emphasis, once again, is mine): –

…collateralized credit operations imply substantially less credit risks (by at least one order of magnitude in our crisis sample) than outright sovereign bond holdings per e1 bn of liquidity owing to a double recourse in the collateralized lending case. Implementing monetary policy via credit operations rather than asset holdings, whenever possible, therefore appears preferable from a risk efficiency perspective. Second, expanding the set of eligible assets during a liquidity crisis could help mitigate the procyclicality inherent in some central bank’s risk protection frameworks.

In other words, rather than exacerbate the widening of credit spreads by purchasing sovereign debt, it is preferable for central banks to lean against the ‘flight to quality’ tendency of market participants during times of stress.

The authors go on to look at recent literature on the stress-testing of central bank balance sheets, mainly focussing on analysis of the US Federal Reserve. Then they review ‘market-risk’ methods as a solution to the ‘credit-risk’ problem, employing non-Gaussian methods – a prescient approach after the unforeseen events of 2008.

Bagehot thou shouldst be living at this hour (with apologies to Wordsworth)

The BIS authors refer on several occasions to Bagehot. I wonder what he would make of the current state of central banking? Please indulge me in this aside.

Walter Bagehot (1826 to 1877) was appointed by Richard Cobden as the first editor of the Economist. He is also the author of perhaps the best known book on the function of the 19th century money markets, Lombard Street (published in 1873). He is famed for inventing the dictum that a central bank should ‘lend freely, at a penalty rate, against good collateral.’ In fact he never actually uttered these words, they have been implied. Even the concept of a ‘lender of last resort’, to which he refers, was not coined by him, it was first described by Henry Thornton in his 1802 treatise – An Enquiry into the Nature and Effects of the Paper Credit of Great Britain.

To understand what Bagehot was really saying in Lombard Street, this essay by Peter Conti-Brown – Misreading Walter Bagehot: What Lombard Street Really Means for Central Banking – provides an elegant insight: –

Lombard Street was not his effort to argue what the Bank of England should do during liquidity crises, as almost all people assume; it was an argument about what the Bank of England should openly acknowledge that it had already done.

Bagehot was a classical liberal, an advocate of the gold standard; I doubt he would approve of the nature of central banks today. He would, I believe, have thrown his lot in with the likes of George Selgin and other proponents of Free Banking.

Conclusion and Investment Opportunities

Given the weakness of European economies it seems unlikely that the ECB will be able to follow the lead of the Federal Reserve and raise interest rates in any meaningful way. The unwinding of, at least a portion of, QE might be easier, since many of these refinancing operations will naturally mature. For arguments both for and against CB balance sheet reduction this paper by Charles Goodhart – A Central Bank’s optimal balance sheet size? is well worth reviewing. A picture, however, is worth a thousand words, although I think the expected balance sheet reduction may be overly optimistic: –

http___com.ft.imagepublish.upp-prod-eu.s3.amazonaws

Source: IMF, Haver Analytics, Fulcrum Asset Management

Come the next crisis, I expect the ECB to broaden the range of eligible securities and instruments that it is prepared to purchase. The ‘Draghi Put’ will gain greater credence as it encompasses a wider array of credits. The ‘Flight to Quality’ effect, driven by swathes of investors forsaking equities and corporate bonds, in favour of ‘risk-free’ government securities, will be shorter-lived and less extreme. The ‘Convergence Trade’ between the yields of European government bonds will regain pre-eminence; I can conceive the 10yr BTP/Bund spread testing zero.

None of this race to zero will happen in a straight line, but it is important not to lose sight of the combined power of qualitative and quantitative easing. The eventual ‘socialisation’ of common stock is already taking place in Japan. Make no mistake, it is already being contemplated by a central bank near you, right now.

Not waving but drowning – Stocks, debt and inflation?

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Macro Letter – No 103 – 26-10-2018

Not waving but drowning – Stocks, debt and inflation?

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

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

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

I was much further out than you thought

And not waving but drowning.

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

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

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

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

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

Wither the stock market?

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

united-states-inflation-cpi 1970 to 2018

Source: Trading Economics

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

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

Conclusions and investment opportunities

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

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

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

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

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

We are much further out than we thought,

And not waving but drowning.

Inflation or Employment

Inflation or Employment

In the Long Run - small colour logo

Macro Letter – No 95 – 20-04-2018

Inflation or Employment

  • Inflationary fears are growing and US rates continue to rise
  • Employment has become more flexible since the crisis of 2008/2009
  • Commodity prices have risen but from multi-year lows
  • During the next recession job losses will rapidly temper inflationary pressures

Given the official policy response to the Great Financial Recession – a mixture of central bank balance sheet expansion, lower for longer interest rates and a general lack of fiscal rectitude on the part of developed nation governments – I believe there are two factors which are key for stock markets over the next few years, inflation and employment. The fact that these also happen to be the two mandated targets of the Federal Reserve – full employment and price stability – is more than coincidental. My struggle is in attempting to decide whether demand-pull inflation can survive the impact of a rapid rise in unemployment come the next recession.

Inflation and the Central Bankers response is clearly the new narrative of the financial markets. In his latest essay, Ben Hunt of Salient Partners makes some fascinating observations – Epsilon Theory: The Narrative Giveth and The Narrative Taketh Away:-

This market, like all markets, cares about two things and two things only — the price of money and the real return on invested capital. Or, as they are typically represented in cartoon form, interest rates and growth.

…This market, like all markets, needs a positive narrative on risk (the price of money) or reward (the real return on capital) to go up. Any narrative will do! But when neither risk nor reward is represented with a positive narrative, this market, like all markets, will go down. And that’s where we are today. 

Does the Fed have our back? No, they do not. They’ve told us and told us that they’re going to keep raising rates. And they will. The market still doesn’t fully believe them, and that’s going to be a constant source of market disappointment over the next few years. In the same way that markets go up as they climb a wall of worry, so do markets go down as they descend a wall of hope. The belief that central bankers care more about the stock market than the price stability of money is that wall of hope. It’s a forlorn hope.

The author goes on to discuss the way that inflation and the war on trade has derailed the global synchronized growth narrative. Dr Hunt writes at length about narratives; those who have been reading my letters for a while will know I regularly quote from his excellent Epsilon Theory.

The narrative has not yet become flesh, to coin a phrase, but in the author’s opinion it will:-

My view: the inflation narrative will surge again, as wage inflation is, in truth, not contained at all.

The trade war narrative hit markets in force in late February with the White House announcement on steel and aluminum tariffs. It subsided through mid-March as hope grew that Trump’s bark was worse than his bite, then resurfaced in late March with direct tariff threats against China, then subsided again on hopes that direct negotiations would contain the conflict, and has now resurfaced this past week with still more direct tariff threats against and from China. Already this weekend you’ve got Kudlow and other market missionaries trying to rekindle the hope of easy negotiations. But being “tough on trade” is a winning domestic political position for both Trump and Xi, and domestic politics ALWAYS trumps (no pun intended) international economics. 

My view: the trade war narrative will be spurred on by BOTH sides, and is, in truth, not contained at all.

The two charts below employ natural language processing techniques. They show how the inflation narrative has rapidly increased during the last 12 months. I shall leave Dr Hunt to elucidate:-

… analysis of a large set of market relevant articles — in this case everything Bloomberg has published that talks about inflation — where linguistic similarities create clusters of articles with similar meaning (essentially a linguistic “gravity model”), and where the dynamic relationships between and within these clusters can be measured over time.

epsilon-theory-the-narrative-giveth-and-the-narrative-taketh-away-april-10-2018-chart-one

Source: Quid.inc

What this chart shows is the clustering of content in 1,400 Bloomberg articles, which mention US inflation, between April 2016 and March 2017. The graduated colouring – blue earlier and red later in the year – enriches the analysis.

The next chart is for the period April 2017 to March 2018:-

epsilon-theory-the-narrative-giveth-and-the-narrative-taketh-away-april-10-2018-chart-two

Source: Quid.Inc

During this period there were 2,400 articles (a 75% increase) but, of more relevance is the dramatic increase in clustering.

What is clear from these charts is the rising importance of inflation as a potential driver of market direction. Yet there are contrary signals that suggest that economic and employment growth are already beginning to weaken. Can inflation continue to rise in the face of these headwinds. Writing in The Telegraph, Ambrose Evans-Pritchard has his doubts (this transcript is care of Mauldin Economics) – JP Morgan fears Fed “policy mistake” as US yield curve inverts:-

US jobs growth fizzled to stall-speed levels of 103,000 in March. The worldwide PMI gauge of manufacturing and services has dropped to a 14-month low. The average “Nowcast” tracker of global growth has slid suddenly to a quarterly rate of 3.2pc from 4.1pc as recently as early February.

Analysts at JP Morgan say the forward curve for the one-month Overnight Index Swap rate (OIS) – a market proxy for the Fed policy rate – has flattened and “inverted” two years ahead. This is a collective bet by big institutional investors and fund managers that interest rates may be falling by then.

…The OIS yield curve has inverted three times over the last two decades. In 1998 it proved to be a false alarm because the Greenspan Fed did a pirouette and flooded the system with liquidity. In 2000 it was a clear precursor of recession. In 2005 it signaled that the US housing boom was already starting to deflate.

…Growth of the “broad” M3 money supply in the US has slowed to a 2pc rate over the last three months (annualised)…pointing to a “growth recession” by early 2019. Narrow real M1 money has actually contracted slightly since November.

…RBC Capital Markets says this will drain M3 money by roughly $300bn a year…

…Three-month Libor rates – used to set the cost of borrowing on $9 trillion of US and global loans, and $200 trillion of derivatives – have surged 60 basis points since January.

…The signs of a slowdown are even clearer in Europe…Citigroup’s economic surprise index for the region has seen the worst four-month deterioration since 2008.  A reduction in the pace of QE from $80bn to $30bn a month has removed a key prop. The European Central Bank’s bond purchase programme expires altogether in September.

…The global money supply has been slowing since last September. The Baltic Dry Index measuring freight rates for dry goods peaked in mid-December and has since dropped 45pc.

Which brings us neatly to the commodity markets. Are real assets a safe place to hide in the coming inflationary (or perhaps stagflationary) environment? Will the lack of capital investment, resulting from the weakness in commodity prices following the financial crisis, feed through to cost-push inflation?

The trouble with commodities

Commodities are an excellent portfolio diversifier because they tend to be uncorrelated with stock, bonds or real estate. They have a weakness, however, since to invest in commodities one needs to accept that over the long run they have a negative real-expected return. Why? Because of man’s ingenuity. We improve our processes and invest in new technologies which reduce our production costs. We improve extraction techniques and enhance acreage yields. You cannot simply buy and hold commodities: they are trading assets.

Demand and supply of commodities globally is a complex challenge to measure; for grains, oilseeds and cotton the USDA World Agricultural Supply and Demand Estimates for March offers a fairly balanced picture:-

World 2017/18 wheat supplies increased this month by nearly 3.0 million tons as production is raised to a new record of 759.8 million

Global coarse grain production for 2017/18 is forecast 7.0 million tons lower than last month to 1,315.0 million

Global 2017/18 rice production is raised 1.2 million tons to a new record led by 0.3- million-ton increases each for Brazil, Burma, Pakistan, and the Philippines. Global rice exports are raised 0.8 million tons with a 0.3-million-ton increase for Thailand and 0.2- million-ton increases each for Burma, India, and Pakistan. Imports are raised 0.5 million tons for Indonesia and 0.3 million tons for Bangladesh. Global domestic use is reduced fractionally. With supplies increasing and total use decreasing, world ending stocks are raised 1.4 million tons to 144.4 million and are the second highest stocks on record.

Global oilseed production is lowered 5.7 million tons to 568.8 million, with a 6.1-million-ton reduction for soybean production and slightly higher projections for rapeseed, sunflower seed, copra, and palm kernel. Lower soybean production for Argentina, India, and Uruguay is partly offset by higher production for Brazil.

Cotton – Lower global beginning stocks this month result in lower projected 2017/18 ending stocks despite higher world production and lower consumption. World beginning stocks are 900,000 bales lower this month, largely attributable to historical revisions for Brazil and Australia. World production is about 250,000 bales higher as a larger Brazilian crop more than offsets a decline for Sudan. Consumption is about 400,000 bales lower as lower consumption in India, Indonesia, and some smaller countries more than offsets Vietnam’s increase. Ending stocks for 2017/18 are nearly 600,000 bales lower in total this month as reductions for Brazil, Sudan, the United States, and Australia more than offset an increase for Pakistan.

It is worth remembering that local market prices can be dramatically influenced by small changes in regional supply or demand and the vagaries of supply chain logistics. Added to which, for US grains there is heightened anxiety regarding tariffs: they are expected to be the main target of the Chinese retaliation.

Here is the price of US Wheat since 2007:-

Wheat since 2007

Source: Trading Economics

Crisis? What crisis? It is still near to multi-year lows, although above the nadir of the financial crisis in 2009.

The broader CRB Index shows a more pronounced recovery, it has been rising since the beginning of 2016:-

CRB Index since 2007 Core Commodity Indexes

Source: Reuters, Core Commodity Indexes

Neither of these charts suggest that price momentum is that robust.

Another (and, perhaps, more global) measure of economic activity is the Baltic Dry Freight Index. This chart shows a very different reaction to the synchronised increase in world economic growth:-

Baltic Dry Index - Quandl since 2007

Source: Quandl

In absolute terms the index has more than tripled in price from the 2016 low, nonetheless, it is still in the lower half of the range of the past decade.

Global economic growth may have encouraged a rebound in Copper, another industrial bellwether, but it appears to have lost some momentum of late:-

Copper Since 2007

Source: Trading Economics

Brent Crude Oil also appears to be benefitting from the increase in economic activity. It has doubled from its low of two years ago. The US rig count has increased in response but at 800 it remains at half the level of a few years ago:-

Brent Oil Since 2007

Source: Trading Economics

US Natural Gas, which might still manage an upward price spike on account of the unseasonably cold weather in the US, provides a less compelling argument:-

US Nat Gas Since 2007

Source: Trading Economics

Commodity markets are clearly off their multi-year lows, but the strength of momentum looks mixed and, in grains and oil seeds, global supply and demand look fairly balanced. Cost push inflation may be a factor in certain markets, but, without price-pull demand, inflation pressures are likely to be short-lived. Late cycle increases in commodity prices are quite common, however, so we may experience a short-run stagflationary squeeze on incomes.

Conclusions and investment opportunities

When ever I write about commodities in a collective way, I remind readers that each market is unique, pretending they are homogenous is often misleading. The recent rise in Cocoa, after a two-year downtrend resulting from an increase in global supply, is a classic example. The time it takes to grow a Cocoa plant governs the length of the cycle. Similarly, the lead time for producing a new ship is a major factor in determining the length of the freight rate cycle. Nonetheless, at the risk of contradicting myself, what may keep a bid under commodity markets is the low level of capital investment which has been a hall-mark of the long, listless recovery from the great financial recession. I believe an economic downturn is likely and job losses will occur rapidly in response.  

I entitled this letter ‘Inflation or Employment’, these are the factors which will dominate Central Bank policy. Currently commentators view inflation as the greater concern, as Dr Hunt’s research indicates, but I believe those Central Bankers who can (by which I mean the Federal Reserve) will attempt to insure they have raised interest rates to a level from which they can be cut, rather than having to rely on ever more unorthodox monetary policies.

Stocks for the Long Run but not the short

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Macro Letter – No 93 – 23-03-2018

Stocks for the Long Run but not the short

  • In the long run stocks outperform bonds
  • For a decade stocks, bonds and real estate have risen in tandem
  • The risk of a substantial correction is high
  • Value-based equity investment is unfashionably enticing

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.

epsilon-theory-the-three-body-problem-december-21-2017-quality-index-graph

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:-

S&P 1870 to 2018

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.

Stock Mkt correlations July 2017

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:-

CAPE etc Star Capital 28-2-2018

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:-

TOP 10 VALUE SandP500 - Obermatt

Source: Obermatt

Conclusion

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.

Are we nearly there yet? Employment, interest rates and inflation

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Macro Letter – No 92 – 09-03-2018

Are we nearly there yet? Employment, interest rates and inflation

  • Rising interest rates and inflation are spooking financial markets
  • Unemployment data suggests that labour markets are tight
  • Central Banks will have to respond to a collapse in the three asset bubbles

There are two factors, above all others, which are spooking asset markets at present, inflation and interest rates. The former is impossible to measure with any degree of certainty – for inflation is in the eye of the beholder – and the latter is divergent depending on whether you look at the US or Japan – with Europe caught somewhere between the two extremes. In this Macro Letter I want to investigate the long term, demand-pull, inflation risk and consider what might happen if stocks, bonds and real estate all collapse in tandem.

It is reasonable to assume that US rates will rise this year, that UK rates might follow and that the ECB (probably) and BoJ (almost certainly) will remain on the side-lines. An additional worry for export oriented countries, such as Japan and Germany, is the protectionist agenda of the current US administration. If their exports collapse, GDP growth is likely to slow in its wake. The rhetoric of retaliation will be in the air.

For international asset markets, the prospect of higher US interest rates and protectionism, spells lower growth, weakness in employment and a lowering of demand-pull inflationary pressure. Although protectionism will cause prices of certain goods to rise – use that aluminium foil sparingly, baste instead – the overall effect on employment is likely to be swift.

Near-term impact

Whilst US bond yields rise, European bond yields may fail to follow, or even decline, if export growth collapses. Stocks in the US, by contrast, may be buoyed by tax cuts and the short-term windfall effect of tariff barriers. The high correlation between equity markets and the international nature of multinational corporations, means global stocks may remain levitated a while longer. The momentum of recent economic growth may lead to increased employment and higher wages in the near-term – and this might even spur demand for a while – but the spectre of inflation at the feast, will loom like a hawk.

Longer-term effects

But is inflation really going to be a structural problem? In an attempt to answer this we must delve into the murky waters of the employment data. As a starting point, at what juncture can we be confident that the US and other countries at or near to full-employment? Let us start by looking at the labour force participation rate. It is a difficult measure to interpret. As the table below shows, in the US and Japan the trend has been downward whilst the UK and the EU are hitting record highs:-

Labor_Force_Participation_Rates

Source: Trading Economics

One possible reason for this divergence between the EU and the US/Japan is that the upward trend in European labour participation has been, at least partially, the result of an inexorable reduction in the scope and scale of the social safety net throughout the region.

More generally, since the Great Recession of 2008/2009 a number of employment trends have been evident across most developed countries. Firstly, many people have moved from full-time to part-time employment. Others have switched from employment to self-employment. In both cases these trends have exerted downward pressure on earnings. What little growth in earnings there has been, has mainly emanated from the public sector, but rising government deficits make this source of wage growth unsustainable in the long run.

The Record of Meeting of the CAC and Federal Reserve Board of Governors – published last November, stated the following in relation to US employment:-

The data indicate that despite the drop in unemployment, there has not been an increase in the number of quality jobs—those that pay enough to cover expenses and enable workers to save for the future. The 2017 Scorecard reports that one in four jobs in the U.S. is in a low-wage occupation, which means that at the median salary, these jobs pay below the poverty threshold for a family of four. For the first time, the 2017 Scorecard includes a measure of income volatility that shows that one in five households has significant income fluctuations from month to month. The percentage varies by state, from a low of 14.7 percent of households in Virginia to a stunning 29.8 percent of households in Wyoming. In addition, 40 percent of those experiencing volatility reported struggling to pay their bills at least once in the last year because of these income fluctuations. These two factors contribute significantly to the fact that almost 37 percent of U.S. households, and 51 percent of households of color, live in the financial red zone of “liquid asset poverty.” This means that they do not have enough liquid savings to replace income at the poverty level for three months if their main source of income is disrupted, such as from job loss or illness. This level of financial insecurity has profound implications for the security of households, and for the overall economic growth of the nation.

Another trend that has been evident is the increase in the number of people no longer seeking employment. Setting aside those who, for health related reasons, have exited the employment pool, early retirement has been one of the main factors swelling the ranks of the previously employable. For this growing cohort, inflation never went away. In particular, inflation in healthcare has been one of the main sources of increases in the price level over the past decade.

At the opposite end of the working age spectrum, education is another factor which has reduced the participation rate. It has also exerted downward pressure on wages; as more students enrol in higher education in order to gain, hopefully, better paid employment, the increased supply of graduates insures that the economic value of a degree diminishes. Whilst a number of corporations have begun to offer apprenticeships or in-work degree qualifications, in order to address the skill gap between what is being taught and what these firms require from their employees, the overall impact of increased demand for higher education has been to reduce the participation rate.

For a detailed assessment of the situation in the US, this paper from the Kansas City Federal Reserve – Why Are Prime-Age Men Vanishing from the Labor Force? provides some additional and fascinating insights. Here is the author’s conclusion:-

Over the past two decades, the nonparticipation rate among primeage men rose from 8.2 percent to 11.4 percent. This article shows that the nonparticipation rate increased the most for men in the 25–34 age group and for men with a high school degree, some college, or an associate’s degree. In 1996, the most common situation prime-age men reported during their nonparticipation was a disability or illness, while the least common situation was retirement. While the share of primeage men reporting a disability or illness as their situation during nonparticipation declined by 2016, this share still accounted for nearly half of all nonparticipating prime-age men. This result is in line with Krueger’s (2016) finding, as many of these men with a disability or illness are likely suffering from daily pain and using prescription painkillers.

I argue that a decline in the demand for middle-skill workers accounts for most of the decline in participation among prime-age men. In addition, I find that the decline in participation is unlikely to reverse if current conditions hold. In 2016, the share of nonparticipating prime-age men who stayed out of the labor force in the subsequent month was 83.8 percent. Moreover, less than 15 percent of nonparticipating prime-age men reported that they wanted a job. Together, this evidence suggests nonparticipating prime-age men are less likely to return to the labor force at the moment.

The stark increase in prime-age men’s nonparticipation may be the result of a vicious cycle. Skills demanded in the labor market are rapidly changing, and automation has rendered the skills of many less-educated workers obsolete. This lack of job opportunities, in turn, may lead to depression and illness among displaced workers, and these health conditions may become further barriers to their employment. Ending this vicious cycle—and avoiding further increases in the nonparticipation rate among prime-age men—may require equipping workers with the new skills employers are demanding in the face of rapid technological advancements.

For an even more nuanced interpretation of the disconnect between corporate profits and worker compensation this essay by Jonathan Tepper of Varient Perception – Why American Workers Aren’t Getting A Raise: An Economic Detective Story – is even more compelling:-

Rising industrial concentration is a powerful reason why profits don’t mean revert and a powerful explanation for the imbalance between corporations and workers. Workers in many industries have fewer choices of employer, and when industries are monopolists or oligopolists, they have significant market power versus their employees.

The role of high industrial concentration on inequality is now becoming clear from dozens recent academic studies. Work by The Economist found that over the fifteen-year period from 1997 to 2012 two-thirds of American industries were more concentrated in the hands of a few firms. In 2015, Jonathan Baker and Steven Salop found that “market power contributes to the development and perpetuation of inequality.”

One of the most comprehensive overviews available of increasing industrial concentration shows that we have seen a collapse in the number of publicly listed companies and a shift in power towards big companies. Gustavo Grullon, Yelena Larkin, and Roni Michaely have documented how despite a much larger economy, we have seen the number of listed firms fall by half, and many industries now have only a few big players. There is a strong and direct correlation between how few players there are in an industry and how high corporate profits are.

Tepper goes on to discuss monopolies and monopsonies. At the heart of the issue is the zombie company phenomenon. With interest rates at artificially low levels, companies which should have been liquidated have survived. Others have used their access to finance, gained from many years of negotiation with their bankers, to buy out their competitors. If interest rates were correctly priced this would not have been possible – these zombie corporations would have gone to the wall. I wrote a rather long two part essay on this subject in 2016 for the Cobden Centre – A history of Fractional Reserve Banking – or why interest rates are the most important influence on stock market valuations? This is about the long-run even by my standards but I commend it to those of you with an interest in economic history. Here is a brief quote from part 2:-

…This might seem incendiary but, let us assume that the rate of interest at which the UK government has been able to borrow is a mere 300bp below the rate it should have been for the last 322 years – around 4% rather than 7%. What does this mean for corporate financing?

There are two forces at work: a lower than “natural” risk free rate, which should make it possible for corporates to borrow more cheaply than under unfettered conditions. They can take on new projects which would be unprofitable under normal conditions, artificially prolonging economic booms. The other effect is to allow the government to crowd out private sector borrowing, especially during economic downturns, where government borrowing increases at the same time that corporate profitability suffers. The impact on corporate interest rates of these two effects is, to some extent, self-negating. In the long run, excessive government borrowing permanently reduces the economic capacity of the country, by the degree to which government investment is less economically productive than private investment.

To recap, more people are remaining in education, more people are working freelance or part-time and more people are choosing to retire early. The appreciation of the stock, bond and property markets has certainly helped those who are asset rich, choose to exit the ranks of the employable, but, I suspect, in many cases this is only because asset prices have been rising for the past decade. Pension annuity rates appear to have hit all-time lows, a reckoning for asset markets is overdue.

What happens come the next bust and beyond?

If inflation rises and Central Banks respond by raising interest rates, bond prices will fall and stocks will have difficulty avoiding the force of gravity. Once bond and stock markets fall, property prices are likely to follow, as the cost of financing mortgages increases. With all the major asset classes in decline, economic growth will slow and unemployment will rise. Meanwhile, the need to work, in order to supplement the reduction in income derived from a, no longer appreciating, pool of assets, will increase, putting downward pressure on average earnings. Here is the most recent wage, inflation and real wage data. For France, Germany and the UK, wages continue to lag behind prices. A 2% inflation target is all very well, just so long as wages can keep up:-

Wages_and_Inflation

Source: Trading Economics

The first place where this trend in lower earnings will become evident is likely to be among freelance and part-time workers – at least they will still have employment. The next casualty will be the fully employed. Corporations will lay-off staff as corporate profit warnings force their hands. Governments will be beseeched to create jobs and, regardless of whether the inflation rate is still rising or not, Central Banks will be implored, cajoled (whatever it takes) to cut interest rates and renew their quest to purchase every asset under the sun.

Wage deflation will, of course, continue, harming those who have no alternative but to work; those who lack sufficient unearned income to survive. Government debt will accelerate, Central Bank balance sheets will balloon and asset prices will eventually recover. Bond yields may even reach new record lows, prompting assets to flow into stocks – the ones Central Banks have not yet purchased as part of their QQE programmes – despite their inflated valuations. Corporate executives will no doubt take the view that interest rates are artificially low and conclude that they can best serve their shareholders by buying back their own stock – accompanied by the occasional special dividend to avoid accusations for impropriety.

As economic growth takes a nose drive, inflation will moderate, providing justification for the pre-emptive rate cutting and balance sheet expanding actions of the Central Banks. Articles will begin to appear, in esteemed journals, talking of a new era of low economic trend growth. Finally, after several years of QE, QQE and whatever the stage beyond that may be – helicopter money anyone? – the world economy will start to grow more rapidly and the labour force participation rate, increase once more. Inflation will start to rise, interest rates will be tightened, bond yields, increase. At this point, stocks will fall and the next downward leg of the economic cycle will have to be averted by renewed QQE and fiscal stimulus. If this is reminiscent of a scene from Groundhog Day, I regret to inform you, it is.

There will be a point at which the financialisation of the global economy and the nationalisation of the stock market can no longer deliver the markets from the deleterious curse of debt, but, sadly, I do not believe that moment has yet arrived. Are we nearly there yet? Not even close.