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

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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.

 

A warning knell from the housing market – inciting a riot?

A warning knell from the housing market – inciting a riot?

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Macro Letter – No 90 – 02-02-2018

A warning knell from the housing market – inciting a riot?

  • Global residential real estate prices continue to rise but momentum is slowing
  • Prices in Russia continue to fall but Australian house prices look set to follow
  • After a decade of QE, real estate will be more sensitive to interest rate increases

As anyone who owns a house will tell you, all property markets are, ‘local.’ Location is key. Nonetheless, when looking for indicators of a change in sentiment with regard to asset prices in general, residential real estate lends support to equity bull markets. Whilst it usually follows the performance of the stock market, this time it may be a harbinger of austerity to come.

The most expensive real estate is to be found in areas of limited supply; as Mark Twain once quipped, when asked what asset one should invest in, he replied, ‘Buy land, they’re not making it anymore.’ Mega cities are a good example of this phenomenon. They are a sign of progress. As Ian Stewart of Deloittes put it in this week’s Monday Briefing – How distance survived the communication revolution:-

In 2014, for the first time, more of the world’s population, some 54%, lived in urban than rural areas. The UN forecasts this will rise to 66% by 2050. Businesses remain wedded to city locations. More of the UK’s top companies are headquartered in London than a generation ago. The lead that so-called mega cities, those with populations in excess of 10 million, such as Tokyo and Delhi, have over the rest of the country has increased.

Proximity matters, and for good reasons. Cities offer business a valuable shared pool of resources, particularly labour and infrastructure. Bringing large numbers of people and businesses together increase the chances of matching the right person with the right job. The scale of cities improves matching in other areas, from restaurants to education and the choice of a partner. Scale, in terms of the number of businesses, tend to stimulate competition and productivity.  Nor has technology fulfilled its promise to work equally well everywhere. By and large, technology tends to work better in urban areas than the country.

Urbanisation facilitates learning and the diffusion of knowledge, two vital processes for the modern economy. Workers in cities can more easily change jobs without changing homes, enabling the transfer of ideas across businesses. On-line learning has supplemented, but shows few signs of usurping the classroom, lecture theatre or face to face contact. Despite the collapsing cost of communication, competition for entry to the best schools and universities has intensified in the last three decades.

For all the transformative effects of the communication revolution the lead that cities have over the rest of the country seems to be widening. The LSE reports that in the UK workers in urban areas earn 8% more than those elsewhere; in London the premium is 24%. Buoyant property prices in major cities underscore the gap.

The world’s mega-cities have seen the highest house price inflation but at the national level the momentum of house price increases has begun to slow as prices approach the 2008 highs once more. The chart below, care of the IMF, shows the strength of momentum still increasing in Q2 2017:-

globalhousepriceindex

Source: IMF

By Q3 2017 Global Property Guide analysis suggested a sea-change had begun:-

During the year to the third quarter of 2017:

House prices rose in 24 out of the 46 world’s housing markets which have so far published housing statistics, using inflation-adjusted figures.

The more upbeat nominal figures, more familiar to the public, showed house price rises in 38 countries, and declines in 8 countries.

Upwards price momentum is weakening.

Europe, Canada, Hong Kong, and Macau continue to experience strong price rises.  But most of the Middle East, Latin America, New Zealand and some parts of Asia are experiencing either house price falls – or a sharp deceleration of house price rises.

The five strongest housing markets in our global house price survey for the third quarter of 2017 were: Iceland (+18.76%), Hong Kong (+13.14%), Macau (+10.53%), Canada (+9.69%), and Romania (+9.36%).

The biggest y-o-y house-price declines were in Egypt (-8.68%), Kiev, Ukraine (-6.81%), Russia (-6.69%), Mongolia (-5.7%), and Qatar (-2.85%).

Only 15 of the 46 markets analysed showed increased upward momentum. Hardly cause for concern, one might think; after all, during the nine year equity bull-market, stock momentum has waxed and waned. However, one market in particular (which, incidentally, is not covered by Global Property Guide analysis) has seen falling prices during the past quarter – Australia.

As the chart below shows, Australian house prices were among the fastest rising in Q2:-

housepricesaroundtheworld

Source: IMF

Sydney has been even more extreme:-

Sydney-house-price-cycle-nov-2-2017

Source: Core Logic

On the basis that, what goes up must, inevitably, come back down, one could argue that a price correction is needed, however, unlike the stock market, house prices have a much stronger impact on the spending habits of the consumer.

The consumer is impacted by the cost of financing mortgage borrowing and their ability to remortgage, relies on a steady increase in the value of housing stock. Rising bond yields, led by the US, where 10yr yields have broken through 2.62% to the upside this week, are likely to be a cause for concern. In Australia, however, fixed rate deals (where they exist) tend to be only two to three years in duration. The remainder of mortgages are variable rate. 1yr Australian bond yields are higher – touching 1.78% this month – but they are still only 40bp off their August 2016 lows.

Housing affordability is also a function of price to income and price to rent:-

pricetoincome

Source: IMF

Australia remains one of the most expensive places to buy a house, although their planning constrained neighbour New Zealand is even less affordable, which helps to explain the 1.24% fall in prices for Q3.

pricetorent

Source: IMF

Australia is not the most expensive market on a price to rent basis either, yet, despite relatively low interest rates (and rising commodity prices which have supported the currency) residential real estate prices have begun to decline. The table below shows the quarter on quarter and year on year price change for the five major cities as at 31st January:-

Australian_Cities_house_prices_31-1-2018_Core_Logi

Source: CoreLogic

The residential real estate market in Perth has been depressed for several years, but Sydney (led by high-end central Sydney apartments) has begun to follow its western neighbour.

Conclusions and Investment Opportunities

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.

Global Real Estate and the end of QE – Is it time to be afraid?

Global Real Estate and the end of QE – Is it time to be afraid?

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Macro Letter – No 86 – 03-11-2017

Global Real Estate and the end of QE – Is it time to be afraid?

  • Rising interest rates and higher bond yields are here to stay
  • Real estate prices seem not to be affected by higher finance costs
  • Household debt continues to rise especially in advanced economies
  • Real estate supply remains constrained and demand continues to grow

During the past two months two of the world’s leading central banks have begun the process of unwinding or, at least, tapering the quantitative easing which was first initiated after the great financial recession of 2008/2009. The Federal Reserve FOMC statement for September and their Addendum to the Policy Normalization Principles and Plans from June contain the details of the US bank’s policy change. The ECB Monetary policy decision from last week explains the European position.

Whilst the Federal Reserve is reducing its balance sheet by allowing US treasury holdings to mature, the US government has already breached its debt ceiling and will need to issue new bonds. The pace of US money supply growth is unlikely to be reversed. Nonetheless, 10yr US bond yields have risen from a low of 1.35% in July 2016 to more than 2.6% earlier this year. They currently yield around 2.4%. Over the same period 2yr US bond yields have risen from 0.49% to a new high, this week, of 1.60% – their highest since October 2008.

Back in April I wrote about the anomaly in the US interest rate swaps market – US 30yr Swaps have yielded less than Treasuries since 2008 – does it matter? What is interesting to note, in relation to global real estate, is that the 10yr Swap spread over US Treasuries (which is currently negative) has remained stable at -8bp during the recent rise in yields. Normally as interest rates on government bonds declines credit spreads tighten – as rates rise these spreads widen. So far, this has not come to pass.

In the US, mortgages are, predominantly, long-term and fixed rate. US 30yr mortgage rates has also risen since July 2016 – from 2.09% to 3.18% at the end of December. Since then rates have moderated, they now stand at 2.89%, approximately 1% above US 30yr bonds. The chart below shows the spread since July 2016:-

30yr_Mortgage_-_Bond_Spread_July_2016_to_October_2

Source: Federal Reserve Bank of St Louis

Apart from the aberration during the US presidential elections the spread between 30yr US Treasuries and 30yr Mortgages has been steadily narrowing despite the tightening of short term interest rates and the increase in yields across the maturity spectrum.

Mortgage finance costs have increased since July 2016 but by less than 50bp. What impact has this had on real estate prices? The chart below shows the S&P Case-Shiller House Price Index since 2006, the increase in mortgage rates has failed to slow the rise in prices. The year on year increase is currently running at 5.6% and forecasters predict this rate to increase to 5.8% when September data is released:-

SandP_Shiller_Case_House_Price_Index_-_2006-2017_Q

Source: Federal Reserve Bank of St Louis, S&P Case-Shiller

At the global level house prices have not taken out their pre-crisis highs, as this chart from the IMF reveals:-

globalhousepriceindex_lg

Source: IMF, BIS, ECB, Federal Reserve, Savills

The latest IMF – Global Housing Watch – report for Q2 2017 is sanguine. They take comfort from the broad range of macroprudential measures which have been introduced during the past decade.

The IMF go on to examine house price increases on a country by country basis:-

housepricesaroundtheworld_lg

Source: IMF, BIS, ECB, Federal Reserve, Savills, Sinyl Real Estate

The OECD – Focus on house priceslooks at a variety of different metrics including changes in real house prices: the OECD average is more of less where it was in 2010 having dipped during 2011/2012 – here is breakdown across a selection of regions. Please note the charts are rather historic they stop at January 2014:-

OECD Real Estate charts 2010 -2014

Source: OECD

The continued fall in Japanese prices is not entirely surprising but the steady decline of the Euro area is significant.

Similarly historic data is contained in the chart below which ranks countries by Price to Income and Price to Rent. Portugal, Germany, South Korea and Japan remain inexpensive by these measures, whilst Belgium, New Zealand, Canada, Norway and Australia remain expensive. The UK market also appears inflated but the decline in Sterling may be a supportive factor: international capital is flowing into the UK after the devaluation:-

Real Estate P-E and P-R chart OECD

Source: OECD

Bringing the data up to date is the Knight Frank’s global house price index, for Q2 2017. The table below is sorted by real return:-

Real_Estate_Real_Return_Q2_2017_Knight_Frank

Source: Knight Frank, Trading Economics

There is a saying in the real estate market, ‘all property is local’. Prices vary from region to region, from street to street, however, the data above paints a picture of a global real estate market which has performed strongly in response to the lowering of interest rates. As the table below illustrates, the percentage of countries recording positive annual price changes is now at 89%, well above the levels of 2007, when interest rates were higher:-

Real_Estate_Price_Change_-_Knight_Frank

Source: Knight Frank

The low interest rate environment has stimulated a rise in household debt, especially in advanced economies. The IMF – Global Financial Stability Report October 2017 makes sombre reading:-

Although finance is generally believed to contribute to long-term economic growth, recent studies have shown that the growth benefits start declining when aggregate leverage is high. At business cycle frequencies, new empirical studies—as well as the recent experience from the global financial crisis—have shown that increases in private sector credit, including household debt, may raise the likelihood of a financial crisis and could lead to lower growth.

These two charts show the rising trend globally but the relatively undemanding levels of indebtedness typical of the Emerging Market countries:-

IMF_Household_Debt_to_GDP_ratios_-_Advanced_Econom

Source: IMF

IMF_Household_Debt_to_GDP_ratios_-_Emerging_Econom

Source: IMF

As long ago at February 2015 – McKinsey – Debt and (not too much) deleveraging – sounded the warning knell:-

Seven years after the bursting of a global credit bubble resulted in the worst financial crisis since the Great Depression, debt continues to grow. In fact, rather than reducing indebtedness, or deleveraging, all major economies today have higher levels of borrowing relative to GDP than they did in 2007. Global debt in these years has grown by $57 trillion, raising the ratio of debt to GDP by 17 percentage points.

According to the Institute of International Finance Q2 2017 global debt report – debt hit a new all-time high of $217 trln (327% of global GDP) with China leading the way:-

iif china debt to GDP

Source: IIF

Household debt is growing in China but from a relatively low base, it is as the IMF observe, the advanced economies where households are becoming addicted to low interest rates and cheap finance.

Conclusions and investment opportunities

Economist Global House prices

Source: The Economist

The chart above shows a few of the winners since 1980. The real estate market remains sanguine, trusting that the end of QE will be a gradual process. Although as a recent article by Frank Shostak – Can gradual interest rate tightening prevent shocks? reminds us, ‘…there is no such thing as “shock-free” monetary policy’:-

Can a gradual tightening prevent an economic bust?

Since monetary growth, whether expected or unexpected, gives rise to the redirection of real savings it means that any monetary tightening slows down this redirection. Various economic activities, which sprang-up on the back of strong monetary pumping, because of a tighter monetary stance get now less real funding. This in turn means that these activities are given less support and run the risk of being liquidated.  It is the liquidation of these activities what an economic bust is all about.

Obviously, then, the tighter monetary stance by the Fed must put pressure on various false activities, or various artificial forms of life. Hence, the tighter the Fed gets the slower the pace of redirection of real savings will be, which in turn means that more liquidation of various false activities will take place. In the words of Ludwig von Mises,

‘The boom brought about by the banks’ policy of extending credit must necessarily end sooner or later. Unless they are willing to let their policy completely destroy the monetary and credit system, the banks themselves must cut it short before the catastrophe occurs. The longer the period of credit expansion and the longer the banks delay in changing their policy, the worse will be the consequences of the malinvestments and of the inordinate speculation characterizing the boom; and as a result the longer will be the period of depression and the more uncertain the date of recovery and return to normal economic activity.’

Consequently, the view that the Fed can lift interest rates without any disruption doesn’t hold water. Obviously if the pool of real savings is still expanding then this may mitigate the severity of the bust. However, given the reckless monetary policies of the US central bank it is quite likely that the US economy may already has a stagnant or perhaps a declining pool of real savings. This in turn runs the risk of the US economy falling into a severe economic slump.

We can thus conclude that the popular view that gradual transparent monetary policies will allow the Fed to tighten its stance without any disruptions is based on erroneous ideas. There is no such thing as a “shock-free” monetary policy any more than a monetary expansion can ever be truly neutral to the market.

Regardless of policy transparency once a tighter monetary stance is introduced, it sets in motion an economic bust. The severity of the bust is conditioned by the length and magnitude of the previous loose monetary stance and the state of the pool of real savings.

If world stock markets catch a cold central banks will provide assistance – though not perhaps to the same degree as they did last time around. If, however, the real estate market begins to unravel the impact on consumption – and therefore on the real economy – will be much more dramatic. Central bankers will act in concert and with determination. If the problem is malinvestment due to artificially low interest rates, then further QE and a return to the zero bound will not cure the malady: but this discussion is for another time.

What does quantitative tightening – QT – mean for real estate? In many urban areas, the increasing price of real estate is a function of geography and the limitations of infrastructure. Shortages of supply are difficult (and in some cases impossible) to alleviate; it is unlikely, for example, that planning consent would be granted to develop Central Park in Manhattan or Hyde Park in London.

Higher interest rates and weakness in household earnings growth will temper the rise in property prices. If the markets run scared it may even lead to a brief correction. More likely, transactional activity will diminish. A price collapse to the degree we witnessed in 2008/2009 is unlikely to recur. Those markets which have risen most may exhibit a greater propensity to decline, but the combination of steady long term demand and supply constraints, will, if you’ll pardon the pun, underpin global real estate.

Japan – Politics, Central Banking and the Nikkei 225

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Macro Letter – No 84 – 29-09-2017

Japan – Politics, Central Banking and the Nikkei 225

  • PM Abe called a snap general election for October, amid rising geopolitical tensions
  • The BoJ maintain QQE despite Federal Reserve plans to reduce its balance sheet
  • Japanese stocks will benefit if the ‘Three Arrows’ of Abenomics continue
  • Japanese wages are rising whilst inflation is stuck at zero

On Monday Japanese Prime Minister, Shinzo Abe, called a snap general election. During the press conference in which he made the announcement he said:-

It is my mission as prime minister to exert strong leadership abilities at a time when Japan faces national crises stemming from the shrinking demographic and North Korea’s escalating tensions…

He went on to outline a JPY 2trln stimulus package, to be implemented before year end. This will be financed by raising the consumption tax rate from 8% to 10% in October 2019. The tax increase is expected to generate JPY 5trln/annum and, if any revenue remains after the stimulus, it will be used to reduce government debt. With a further JPY 2trln earmarked for education and social programmes it seems unlikely the maths will add up.

Meanwhile, despite the Federal Reserve’s announcement, last week, that they will begin balance sheet reduction, the Bank of Japan (BoJ) continue their policy of quantitative and qualitative easing (QQE) involving the unorthodox ‘yield curve control’ measures. From more on this please see Macro Letter – No 65 – Yield Curve Control – the road to infinite QE which I published in November 2016. I stand by my conclusion, although my prediction about the JPY (I thought it would continue to weaken) has yet to come to pass:-

If zero 10 year JGB yields are unlikely to encourage banks to lend and demand from corporate borrowers remains negligible, what is the purpose of the BoJ policy shift? I believe they are creating the conditions for the Japanese government to dramatically increase spending, safe in the knowledge that the JGB yield curve will only steepen beyond 10 year maturity.

I do not believe yield curve control will improve the economics of bank lending at all. According to World Bank data the average maturity of Japanese corporate syndicated loans in 2015 was 4.5 years whilst for corporate bonds it was 6.9 years. Corporate bond issuance accounted for only 5% of total bond issuance in Japan last year – in the US it was 24%. Even with unprecedented low interest rates, demand to borrow for 15 years and longer will remain de minimis.

Financial markets will begin to realise that, whilst the BoJ has not quite embraced the nom de guerre of “The bank that launched Helicopter Money”, they have, assuming they don’t lose their nerve, embarked on “The road to infinite QE”. Under these conditions the JPY will decline and the Japanese stock market will rise.

In the long run demographic forces may halt Abenomic attempts to debase the Yen. This 2015 paper from the Federal Reserve Bank of St Louis – Aging and the Economy: The Japanese Experience – makes fascinating reading. Here is a snippet, but I urge you to read the whole article for an overview of the impact of an ageing population on economies in general, Japan exhibits some unique characteristics in this respect:-

In a third study, economists Derek Anderson, Dennis Botman and Ben Hunt found that the increased number of pensioners in Japan led to a sell-off of financial assets by retirees, who needed the money to cover expenses. The assets were mostly invested in foreign bonds and stocks. The sell-off, in turn, fueled appreciation of the yen, lowering costs of imports and leading to deflation.

Returning to the current environment, on Monday, in a speech to business leaders in Osaka entitled – Japan’s Economy and Monetary PolicyBoJ Governor Haruhiko Kuroda made several observations about the economy, labour market and inflation:-

The economy is expanding moderately, and the real GDP growth rate for the April-June quarter registered a firm increase of 2.5 percent on an annualized basis. It is the first time in eleven years, since 2006, that it has continued to mark positive growth for six consecutive quarters…

The year-on-year rate of increase in hourly wages of part-time employees, which are particularly sensitive to the tightening of the labor market, has registered about 2.5 percent. This is higher than that of full-time employees, implying that the difference in wage levels between part-time and full-time employees has become smaller…

In the labor market as a whole, the unemployment rate has declined to around 3 percent, which is equivalent to virtually full employment, and the active job openings-to-applicants ratio stands at 1.52, exceeding the highest figure during the bubble period and reaching a level last seen as far back as in 1974…

The year-on-year rate of change in the consumer price index (CPI) excluding fresh food has increased to around 0.5 percent recently, but that which also excludes the effects of a rise in energy prices has been relatively weak, remaining at around 0 percent…

Kuroda-san went on to defend the BoJ 2% inflation target and explain the logic behind their ‘QQE with Yield Curve Control’ mechanism. I am struck by the improving affluence of the average worker in Japan. Inflation is zero whilst wage growth, except for the dip in July to -0.3%, has been positive for most of this decade. Real Japanese wages have been rising which is in stark contrast to many of its G7 peers. See Pew Research – For most workers, real wages have barely budged for decades for more on this subject.

The minutes of the July 19th/20th BoJ – Monetary Policy Meeting – were released on Tuesday.  They left policy unchanged. The short-term interest rate target at -0.10% and the long-term rate (10yr JGB yield) at around zero. Commenting on the economy they noted continued solid investment, especially by larger firms and the sustained improvement in private consumption. The consumption activity index (CAI) for Q1 2017 showed a fourth consecutive quarterly increase. I was interested in the statement highlighted below (the emphasis is mine):-

…members shared the view that, with corporate profits improving, which mainly reflected the growth in overseas economies, business fixed investment plans were becoming solid on the whole. They also shared the recognition that the employment and income situation had improved steadily and private consumption had increased its resilience. Members then concurred that a positive output gap had taken hold, given the recent tightening of labor market conditions and the increase in capacity utilization rates, with the latter reflecting a rise in production. Based on this discussion, they agreed to revise the Bank’s economic assessment upward to one stating that Japan’s economy “is expanding moderately, with a virtuous cycle from income to spending operating” from the previous one stating that the economy “has been turning toward a moderate expansion.” One member pointed out that Japan’s economy was shifting from a recovery dependent on external demand to a more self-sustaining expansion brought about by an improvement in domestic demand. This member continued that it was also becoming evident that improvements in economic activity had been spreading across a wider range of areas, urban to regional.

The current QQE policies were reconfirmed (emphasis mine):-

With regard to the amount of JGBs to be purchased, it would conduct purchases at more or less the current pace — an annual pace of increase in the amount outstanding of its JGB holdings of about 80 trillion yen — aiming to achieve the target level of the long-term interest rate specified by the guideline.

With regard to asset purchases other than JGB purchases, many members shared the recognition that it was appropriate for the Bank to implement the following guideline for the intermeeting period. First, it would purchase exchange-traded funds (ETFs) and Japan real estate investment trusts (J-REITs) so that their amounts outstanding would increase at annual paces of about 6 trillion yen and about 90 billion yen, respectively. Second, as for CP and corporate bonds, it would maintain their amounts outstanding at about 2.2 trillion yen and about 3.2 trillion yen, respectively.

An independent summation of the current environment and the prospects for the Japanese economy comes from an article by Kazumasa Iwata – President of the Japan Center for Economic Research – AJISS – The Future of the Japanese Economy: The Great Convergence and Two Great Unwindings:-

Since bottoming out in November 2012, the Japanese economy has been in an expansionary phase that reached its 58th month in September of this year. Although not yet as long as the economic expansion achieved during the Koizumi reforms (73 months), the current phase exceeded the mark set by the Izanagi boom of the late 1960s (57 months). While this phase is technically termed expansionary, it lacks strength. In contrast to the average growth rate of 1.8% seen during the Koizumi reforms, the average rate in the ongoing expansion has only been about 1%.

The economic strategy underlying Abenomics is to put the Japanese economy on the road to 2% growth. The experiences of the Koizumi reforms demonstrate that it is quite possible to realize 2% growth by implementing an effective growth strategy. This is evidenced by the theory of convergence through technology diffusion. The catch-up attained by China, India and other emerging countries since the 1990s through offshoring and the construction of global value chains has been astounding. Professor Richard Baldwin argues that the start of the Industrial Revolution ushered in an era of Great Divergence for the global economy via technological innovation and capital accumulation in the developed countries and elsewhere, and that from the 1990s we have been in an age of Great Convergence due to rapid drops in information and telecommunications costs.

In contrast to the brisk development enjoyed by emerging countries, Japan has found itself in a two-decade-long period of stagnation, its economy falling far below the convergence line predicted by Convergence Theory…

Japan already failed to boost its productivity during the 1st IT Revolution of the mid-1990s, and it is now in the 2nd IT Revolution, otherwise known as the 4th Industrial Revolution, centered on IoT, AI, and Big Data. OECD research shows that the top 5% frontier companies have not seen a decline in productivity growth since the financial crisis. Other companies lag behind these frontier companies in globalizing and using digital technology (digitalization), which has only widened the productivity gap between them. Were all companies in Japan able to boost their performance on par with the top ten companies utilizing AI and IoT, Japan’s growth rate could be accelerated by 4% (JCER 2017).

It is interesting to note that Iwata-san sees the greatest risk coming from the unwinding of QE by the Federal Reserve and the ECB, combined with the increasingly protectionist stance of US trade policy. He does not appear to expect the BoJ to reverse QQE, nor Abenomics to falter.

Market Impact

What does the forthcoming election and continuation of infinite QQE mean for Japanese financial markets? Firstly here are three 10 year charts, of the USDJPY, 10yr JGBs and the Nikkei 225:-

USDJPY 10yr - monthly - Tradingeconomics

Source: Trading Economics

!0yr JGB - 10yr monthly - Tradingeconomics

Source: Trading Economics

Nikkei 225 - 10yr monthly - Tradingeconomics

Source: Trading Economics

The Yen has been trading a range this year; it has strengthened against a generally weakening US$, whilst weakening against a resurgent Euro. 10yr JGBs have been held in an effective straightjacket by ‘Yield curve control’. Meanwhile the Nikkei 225 has followed the lead of other equity markets, both in Asia and the US, and marched steadily higher. A break above the highs of August 2015 would see the index trading at its highest since 1997. A dividend yield of 2% (source: Star Capital – as at 30/6/2017) looks attractive compared to JGBs or inflation, although a P/E ratio of more than 17 times and a CAPE ratio above 26 may be cause for caution.

An assessment of financial markets would not be complete without a review of real estate. The BoJ mentioned that house prices have been fairly flat this year. Below is a r chart of the Japan Housing Index and the CPI Index since the financial crisis of 2008:-

Japan Housing Price Index and CPI 10yr Trading Economics

Source: Trading Economics, Japan Ministry of Internal Affairs

Real Estate rental yields are currently around 2.5% making property an alternative to stocks for the long term investor. Personally, with dividend yields around 2%, I would want more than 50 basis points to invest in such an illiquid asset: chacun a son gout.

The Geopolitics of North Korea makes Japan vulnerable: Japan’s currency will bear the brunt of this. Given that much of the recent economic growth has been export led, this Yen weakness is unlikely to damage the prospects for the stock market, except perhaps in the short-term.

If Abe wins a convincing mandate on 22nd October, military spending may be added to the mix of public sector stimulus. Pervious consumption tax increases have proved damaging to the nascent economic recovery, this time, dare I say it, might be different. With wages increasing and domestic demand finally beginning to rise, a moderate tax hike maybe achievable, although I still think it more likely that implementation will be deferred.

The table below, which shows the top 10 best value stocks in the Nikkei, was calculated on 28th April. It is produced by Obermatt – click on the name to find out more about Obermatt’s excellent range of services and their valuation methodologies:-

Nikkei_225_-_Top_10_-_Obermatt_-_28-4-2017

Source: Obermatt 

To be clear, being a top-down macro investor, I have not personally delved into the relative merits of the stocks above, but I am comforted to note that most of them are household names, even outside Japan. A testament to the quality of many Japanese corporations.

From a technical perspective one should have bought the chart breakout back in November 2016. The market is close to resistance at 21,000 and I would like to see a monthly close above this level before risking additional capital, however, after nearly three decades of deflationary adjustment, the Japanese economy may be beginning to find sustainable growth. I believe this is despite, rather than as a result of, government and central bank policy: but that’s a topic for another time.

 

 

Central Bank balance sheet adjustment – a path to enlightenment?

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Macro Letter – No 79 – 16-6-2017

Central Bank balance sheet adjustment – a path to enlightenment?

  • The balance sheets of the big four Central Banks reached $18.4trln last month
  • The Federal Reserve will commence balance sheet adjustment later this year
  • The PBoC has been in the vanguard, its experience since 2015 has been mixed
  • Data for the UK suggests an exit from QE need not precipitate a stock market crash

The Federal Reserve (Fed) is about to embark on a reversal of the Quantitative Easing (QE) which it first began in November 2008. Here is the 14th June Federal Reserve Press Release – FOMC issues addendum to the Policy Normalization Principles and Plans. This is the important part:-

For payments of principal that the Federal Reserve receives from maturing Treasury securities, the Committee anticipates that the cap will be $6 billion per month initially and will increase in steps of $6 billion at three-month intervals over 12 months until it reaches $30 billion per month.

For payments of principal that the Federal Reserve receives from its holdings of agency debt and mortgage-backed securities, the Committee anticipates that the cap will be $4 billion per month initially and will increase in steps of $4 billion at three-month intervals over 12 months until it reaches $20 billion per month.

The Committee also anticipates that the caps will remain in place once they reach their respective maximums so that the Federal Reserve’s securities holdings will continue to decline in a gradual and predictable manner until the Committee judges that the Federal Reserve is holding no more securities than necessary to implement monetary policy efficiently and effectively.

On the basis of their press release, the Fed balance sheet will shrink until it is nearer $2.5trln versus $4.4trln today. If they stick to their schedule that should take until the end of 2021.

The Fed is likely to be followed by the other major Central Banks (CBs) in due course. Their combined deleveraging is unlikely to go unnoticed in financial markets. What are the likely implications for bonds and stocks?

To begin here are a series of charts which tell the story of the Central Bankers’ response to the Great Recession:-

Central_Bank_Balance_Sheets_-_Yardeni_May_2017

 Source: Yardeni Research, Haver Analytics

Since 2008 the balance sheets of the four major CBs have grown from around $6.5trln to $18.4trln. In the case of the People’s Bank of China (PBoC), a reduction began in 2015. This took the form of a decline in its foreign exchange reserves in order to support the weakening RMB exchange rate against the US$. The next chart shows the path of Chinese FX reserves and the Shanghai Stock index since the beginning of 2014. Lagged response or coincidence? Your call:-

China FX reserves and stocks 2014 - 2017

Source: Trading Economics

At a global level, the PBoC balance sheet reduction has been more than offset by the expansion of the balance sheets of the Bank of Japan (BoJ) and European Central Bank (ECB), however, a synchronous balance sheet contraction by all the major CBs is likely to be of considerable concern to financial market participants globally.

An historical perspective

Have CB balance sheets ever been as large as they are today? Indeed they have. The chart below which terminates in 2011, shows the evolution of the Fed balance sheet since its inception in 1913:-

Federal_Reserve_Balance_Sheet_-_History_-_St_Louis

Source: Federal Reserve, Haver Analytics

The increase in the size of the Fed balance sheet during the period of the Great Depression and WWII was related to a number of factors including: gold inflows, what Friedman and Schwartz termed “precautionary demand” for reserves by commercial banks, lack of alternative assets, changes in reserve requirements, expansion of income and war financing.

For a detailed review of all these factors, this paper from 2016 – How was the Quantitative Easing Program of the 1930s Unwound? By Matthew Jaremski and Gabriel Mathy – makes fascinating reading, here’s the abstract:-

Outside of the recent past, excess reserves have only concerned policymakers in one other period: The Great Depression of the 1930s. This historical episode thus provides the only guidance about the Fed’s current predicament of how to unwind from the extensive Quantitative Easing program. Excess reserves in the 1930s were never actively unwound through a reduction in the monetary base. Nominal economic growth swelled required reserves while an exogenous reduction in monetary gold inflows due to war embargoes in Europe allowed banks to naturally reduce their excess reserves. Excess reserves fell rapidly in 1941 and would have unwound fully even without the entry of the United States into World War II. As such, policy tightening was at no point necessary and likely was even responsible for the 1937-1938 recession.

During the period from April 1937 to April 1938 the Dow Jones Industrial Average fell from 194 to 100. Monetarists, such as Friedman, blamed the recession on a tightening of money supply in 1936 and 1937. I don’t believe Friedman’s censure is lost on the FOMC today: past Fed Chair, Ben Bernanke, is regarded as one of the world’s leading authorities on the causes and policy errors of the Great Depression.

But is the size of a CB balance sheet a determinant of the direction of the stock market? A richer data set is to be found care of the Bank of England (BoE). They provide balance sheet data going back to 1694, although the chart below, care of FRED, starts in 1701:-

BoE_Balance_Sheet_to_GDP_since_1701_-_BoE_and_FRED

Source: Federal Reserve, Bank of England

The BoE really only became a CB, in the sense we might recognise today, as a result of the Banking Act of 1844 which granted it a monopoly on the issuance of bank notes. The chart below shows the performance of the FT-All Share Index since 1700 (please ignore the reference to the Pontifical change, this was the only chart, offering a sufficiently long history, which I was able to discover in the public domain):-

UK-equities-1700-2012 Stockmarket Almanac

Source: The Stock Almanac

The first crisis to test the Bank’s resolve was the panic of 1857. During this period the UK stock market barely changed whilst the BoE balance sheet expanded by 21% between 1857 and 1859 to reach 10.5% of GDP: one might, however, argue that its actions were supportive.

The next crisis, the recession of 1867, was precipitated by the end of the American Civil War and, of more importance to the financial system, the demise of Overund and Gurney, “the Bankers Bank”, which was declared insolvent in 1866. Perhaps surprisingly, the stock market remained relatively calm and the BoE balance sheet expanded at a more modest 20% over the two years to 1858.

Financial markets became a little more interconnected during the Panic of 1873. This commenced with the “Gründerzeit” or “Founders” crash on the Vienna Stock Exchange. It sent shockwaves around the world. The UK stock market declined by 31% between 1873 and 1878. The BoE may have exacerbated the decline, its balance sheet contracted by 14% between 1873 and 1875. Thereafter the trend reversed, with an expansion of 30% over the next four years.

I am doubtful about the BoE balance sheet contraction between 1873 and 1875 being a policy mistake. 1873 was in fact the beginning of the period known as the Long Depression. It lasted until 1896. Nine years before the end of this 20 year depression the stock market bottomed (1887). It then rose by 74% over the next 11 years.

The First World War saw the stock market decline, reaching its low in 1917. From juncture it rallied, entirely ignoring the post-war recession of 1919 to 1921. Its momentum was only curtailed by the Great Crash of 1929 and subsequent Great Depression of 1930-1931.

Part of the blame for the severity of the Great Depression may be levelled at the BoE, its balance sheet expanded by 77% between 1928 and 1929. It then remained relatively stable despite Sterling’s departure from the Gold Standard in 1931 and only began to expand again in 1933 and 1934. Its balance sheet as a percentage of GDP was by this time at its highest since 1844, due to the decline in GDP rather than any determined effort to expand the balance sheet on the part of the Old Lady of Threadneedle Street. At the end of 1929 its balance sheet stood at £537mln, by the end of 1934 it had reached £630mln, an increase of just 17% over five traumatic years. The UK stock market, which had bottomed in 1931 – the level it had last traded in 1867 – proceeded to rally for the next five years.

Adjustment without tightening

History, on the basis of the data above, is ambivalent about the impact the size of a CB’s balance sheet has on the financial markets. It is but one of the factors which influences monetary conditions, the others are the availability of credit and its price.

George Selgin described the Fed’s situation clearly in a post earlier this year for The Cato Institute – On Shrinking the Fed’s Balance Sheet. He begins by looking at the Fed pre-2008:-

…the Fed got by with what now seems like a modest-sized balance sheet, the liabilities of which consisted mainly of circulating Federal Reserve notes, supplemented by Treasury and GSE deposit balances and by bank reserve balances only slightly greater than the small amounts needed to meet banks’ legal reserve requirements. Because banks held few excess reserves, it took only modest adjustments to the size of the Fed’s balance sheet, achieved by means of open-market purchases or sales of short-term Treasury securities, to make credit more or less scarce, and thereby achieve the Fed’s immediate policy objectives. Specifically, by altering the supply of bank reserves, the Fed could  influence the federal funds rate — the rate banks paid other banks to borrow reserves overnight — and so keep that rate on target.

Then comes the era of QE – the sea-change into something rich and strange. The purchase of long-term Treasuries and Mortgage Backed Securities is funded using the excess reserves of the commercial banks which are held with the Fed. As Selgin points out this means the Fed can no longer use the federal funds rate to influence short-term interest rates (the emphasis is mine):-

So how does the Fed control credit now? Instead of increasing or reducing the availability of credit by adding to or subtracting from the supply of Fed deposit balances, the Fed now loosens or tightens credit by controlling financial institutions’ demand for such balances using a pair of new monetary control devices. By paying interest on excess reserves (IOER), the Fed rewards banks for keeping balances beyond what they need to meet their legal requirements; and by making overnight reverse repurchase agreements (ON-RRP) with various GSEs and money-market funds, it gets those institutions to lend funds to it.

Between them the IOER rate and the implicit ON-RRP rate define the upper and lower limits, respectively, of an effective federal funds rate target “range,” because most of the limited trading that now goes on in the federal funds market consists of overnight lending by GSEs (and the Federal Home Loan Banks especially), which are not eligible for IOER, to ordinary banks, which are. By raising its administered rates, the Fed encourages other financial institutions to maintain larger balances with it, instead of trading those balances for other interest-earning assets. Monetary tightening thus takes the form of a reduced money multiplier, rather than a reduced monetary base.

Selgin goes on to describe this as Confiscatory Credit Control:-

…Because instead of limiting the overall availability of credit like it did in the past, the Fed now limits the credit available to other prospective borrowers by grabbing more for itself, which it then passes on to the U.S. Treasury and to housing agencies whose securities it purchases.

The good news is that the Fed can adjust its balance sheet with relative ease (emphasis mine):-

It’s only because the Fed has been paying IOER at rates exceeding those on many Treasury securities, and on short-term Treasury securities especially, that banks (especially large domestic and foreign banks) have chosen to hoard reserves. Even today, despite rate increases, the IOER rate of 75 basis points exceeds yields on most Treasury bills.  Were it not for this difference, banks would trade their excess reserves for Treasury securities, causing unwanted Fed balances to be passed around like so many hot-potatoes, and creating new bank deposits in the process. Because more deposits means more required reserves, banks would eventually have no excess reserves to dispose of.

Phasing out ON-RRP, on the other hand, would eliminate the artificial boost that program has been giving to non-bank financial institutions’ demand for Fed balances.

Because phasing out ON-RRP makes more reserves available to banks, while reducing IOER rates reduces banks’ own demand for such reserves, both policies are expansionary. They don’t alter the total supply of Fed balances. Instead they serve to raise the money multiplier by adding to banks’ capacity and willingness to expand their own balance sheets by acquiring non-reserve assets. But this expansionary result is a feature, not a bug: as former Fed Vice Chairman Alan Blinder observed in December 2013, the greater the money multiplier, the more the Fed can shrink its balance sheet without over-tightening. In principle, so long as it sells enough securities, the Fed can reduce its ON-RRP and IOER rates, relative to prevailing market rates, without missing its ultimate policy targets.

Selgin expands, suggesting that if the Fed decide to announce a fixed schedule for adjustment (which they have) then they may employ another tool from their armoury, the Term Deposit Facility:-

…to the extent that the Fed’s gradual asset sales fail to adequately compensate for a multiplier revival brought about by its scaling-back of ON-RRP and IOER, the Fed can take up the slack by sufficiently raising the return on its Term Deposits.

And the Fed’s federal funds rate target? What happens to that? In the first place, as the Fed scales back on ON-RRP and IOER, by allowing the rates paid through these arrangements to decline relative to short-term Treasury rates, its administered rates will become increasingly irrelevant. The same changes, together with concurrent assets sales, will make the effective federal funds rate more relevant, by reducing banks’ excess reserves and increasing overnight borrowing. While the changes are ongoing, the Fed would continue to post administered rates; but it could also revive its pre-crisis practice of announcing a single-valued effective funds rate target. In time, the latter target could once again be more-or-less precisely met, making it unnecessary for the Fed to continue referring to any target range.

With unemployment falling and economic growth steady the Fed are expected to tighten monetary policy further but the balance sheet adjustment needs to be handled carefully, conditions may look benign but the Fed ultimately holds more of the nation’s deposits than at any time since the end of WWII. Bank lending (last at 1.6%) is anaemic at best, as the chart below makes clear:-

Commercial_Bank_Loan_Creation_US

Source: Federal Reserve, Zero Hedge

The global perspective

The implications of balance sheet adjustment for the US have been discussed in detail but what about the rest of the world? In an FT Article – The end of global QE is fast approaching – Gavyn Davies of Fulcrum Asset Management makes some projections. He sees global QE reaching a plateau next year and then beginning to recede, his estimate for the Fed adjustment is slightly lower than the schedule announced last Wednesday:-

Fulcrum_Projections_for_tapering

Source: FT, Fulcrum Asset Management

He then looks at the previous liquidity injections relative to GDP – don’t forget 2009 saw the world growth decline by -0.8%:-

Fulcrum CB Liquidity Injections - March 2017 forecast

Source: IMF, National Data, Haver Analytics, Fulcrum Asset Management

It is worth noting that the contraction of Emerging Market CB liquidity during 2016 was principally due to the PBoc reducing their foreign exchange reserves. The ECB reduction of 2013 – 2015 looks like a policy mistake which they are now at pains to rectify.

Finally Davies looks at the breakdown by institution. The BoJ continues to expand its balance sheet, rising above 100% of GDP, whilst eventually the ECB begins to adjust as it breaches 40%:-

Fulcrum Estimates of CB Balance sheets - March 2017 

Source: Haver Analytics, Fulcrum Asset Management

I am not as confident as Davies about the ECB’s ability to reverse QE. They were never able to implement a European equivalent of the US Emergency Economic Stabilization Act of 2008, which incorporated the Troubled Asset Relief Program – TARP and the bailout of Fannie Mae and Freddie Mac. Europe’s banking system remains inherently fragile.

ProPublica – Bailout Costs – gives a breakdown of cost of the US bailout. The policies have proved reasonable successful and at little cost the US tax payer. Since initiation in 2008 outflows have totalled $623.4bln whilst the inflows amount to $708.4bln: a net profit to the US government of $84.9bln. Of course, with $455bln of troubled assets still outstanding, there is still room for disappointment.

The effect of TARP was to unencumber commercial banks. Freed of their NPL’s they were able to provide new credit to the real economy once more. European banks remain saddled with an abundance of NPL’s; her governments have been unable to agree on a path to enlightenment.

Conclusions and Investment Opportunities

The chart below shows a selection of CB balance sheets as a percentage of GDP. It is up to the end of 2016:-

centralbankbalancesheetgdpratios

SNB: Swiss National Bank, BoC: Bank of Canada, CBC: Central Bank of Taiwan, Riksbank: Swedish National Bank

Source: National Inflation Association

The BoJ has since then expanded its balance sheet to 95.5% and the ECB, to 32%. With the Chinese economy still expanding (6.9% March 2017) the PBoC has seen its ratio fall to 45.4%.

More important than the sheer scale of CB balance sheets, the global expansion has changed the way the world economy works. Combined CB balance sheets ($22trln) equal 21.5% of global GDP ($102.4trln). The assets held are predominantly government and agency bonds. The capital raised by these governments is then invested primarily in the public sector. The private sector has been progressively crowded out of the world economy ever since 2008.

In some ways this crowding out of the private sector is similar to the impact of the New Deal era of 1930’s America. The private sector needs to regain pre-eminence but the transition is likely to be slow and uneven. The tide may be about to turn but the chance for policy mistakes, as flows reverse, is extremely high.

For stock markets the transition to QT – quantitative tightening – may be neutral but the risks are on the downside. For government bond markets there are similar concerns: who will buy the bonds the CBs need to sell? If interest rates normalise will governments be forced to tighten their belts? Will the private sector be in a position to fill the vacuum created by reduced public spending, if they do?

There is an additional risk. Yield curve flattening. Banks borrow short and lend long. When yield curves are positively sloped they can quickly recapitalise their balance sheets: when yield curves are flat, or worse still inverted, they cannot. Increases in reserve requirements have made government bonds much more attractive to hold than other securities or loans. The Commercial Bank Loan Creation chart above may be seen as a warning signal. The mechanism by which CBs foster credit expansion in the real economy is still broken. A tapering or an adjustment of CB balance sheets, combined with a tightening of monetary policy, may have profound unintended consequences which will be magnified by a severe shakeout in over-extended stock and bond markets. Caveat emptor.

Is the “flight to quality” effect breaking down?

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Macro letter – No 61 – 16-09-2016

Is the “flight to quality” effect breaking down?

  • 54% of government bonds offered negative yields at the end of August
  • Corporate bond spreads did not widen during last week’s decline in government bonds
  • Since July the dividend yield on the S&P500 has been higher than the yield on US 30yr bonds
  • In a ZIRP to NIRP world the “capital” risk of government bonds may be under-estimated

Back in 2010 I switched out of fixed income securities. I was much too early! Fortunately I had other investments which allowed me to benefit from the extraordinary rally in government bonds, driven by the central bank quantitative easing (QE) policies.

In the aftermath of Brexit the total outstanding amount of bonds with negative yields hit $13trln – that still leaves $32trln which offer a positive return. This is alarming nonetheless, according to this 10th July article from ZeroHedge, a 1% rise in yields would equate to a mark-to-market loss of $2.4trln. The chart below shows the capital impact of a 1% yield change for different categories of bonds:-

zerohedge_-_100bp_move_in_yields

Source: ZeroHedge

Looked at another way, the table above suggests that the downside risk of holding US Treasuries, in the event of a 1% rise in yields, is 2.8 times greater than holding Investment Grade corporate bonds.

Corporate bonds, even of investment grade, traditionally exhibit less liquidity and greater credit risk, but, in the current, ultra-low interest rate, environment, the “capital” risk associated with government bonds is substantially higher. It can be argued that the “free-float” of government bonds has been reduced by central bank buying. A paper from the IMF – Government Bonds and Their Investors: What Are the Facts and Do They Matter? provides a fascinating insight into government bond holdings by investor type. The central bank with the largest percentage holding is the Bank of England (BoE) 19.7% followed by the Federal Reserve (Fed) 11.5% and the Bank of Japan (BoJ) 8.3% – although the Japanese Post Office, with 29%, must be taken into account as well. The impact of central bank buying on secondary market liquidity may be greater, however, since the central banks have principally been accumulating “on the run” issues.

Since 2008, financial markets in general, and government bond markets in particular, have been driven by central bank policy. Fear about tightening of monetary conditions, therefore, has more impact than ever before. Traditionally, when the stock market falls suddenly, the price of government bonds rises – this is the “flight to quality” effect. It also leads to a widening of the spread between “risk-free” assets and those carrying greater credit and liquidity risk. As the table above indicates, however, today the “capital” risk associated with holding government securities, relative to higher yielding bonds has increased substantially. This is both as a result of low, or negative, yields and reduced liquidity resulting from central bank asset purchases. These factors are offsetting the traditional “flight to quality” effect.

Last Friday, government bond yields increased around the world amid concerns about Fed tightening later this month – or later this year. The table below shows the change in 10yr to 30yrs Gilt yields together with a selection of Sterling denominated corporate bonds. I have chosen to focus on the UK because the BoE announced on August 4th that they intend to purchase £10bln of Investment Grade corporate bonds as part of their Asset Purchase Programme. Spreads between Corporates and Gilts narrowed since early August, although shorter maturities benefitted most.

Issuer Maturity Yield Gilt yield Spread over Gilts Corporate Change 7th to 12th Gilts change 7th to 12th
Barclays Bank Plc 2026 3.52 0.865 2.655 0.19 0.18
A2Dominion 2026 2.938 0.865 2.073 0.03 0.18
Sncf 2027 1.652 0.865 0.787 0.18 0.18
EDF 2027 1.9 0.865 1.035 0.19 0.18
National Grid Co Plc 2028 1.523 0.865 0.658 0.19 0.18
Italy (Republic of) 2028 2.891 0.865 2.026 0.17 0.18
Kreditanstalt fuer Wiederaufbau 2028 1.187 0.865 0.322 0.18 0.18
EIB 2028 1.347 0.865 0.482 0.18 0.18
BT 2028 1.976 0.865 1.111 0.2 0.18
General Elec Cap Corp 2028 1.674 0.865 0.809 0.2 0.18
Severn Trent 2029 1.869 1.248 0.621 0.19 0.18
Tesco Plc 2029 4.476 1.248 3.228 0.2 0.18
Procter & Gamble Co 2030 1.683 1.248 0.435 0.2 0.18
RWE Finance Bv 2030 3.046 1.248 1.798 0.17 0.22
Citigroup Inc 2030 2.367 1.248 1.119 0.2 0.22
Wal-mart Stores 2030 1.825 1.248 0.577 0.2 0.22
EDF 2031 2.459 1.248 1.211 0.22 0.22
GE 2031 1.778 1.248 0.53 0.21 0.22
Enterprise Inns plc 2031 6.382 1.248 5.134 0.03 0.22
Prudential Finance Bv 2031 3.574 1.248 2.326 0.19 0.22
EIB 2032 1.407 1.248 0.159 0.2 0.22
Kreditanstalt fuer Wiederaufbau 2032 1.311 1.248 0.063 0.19 0.22
Vodafone Group PLC 2032 2.887 1.248 1.639 0.24 0.22
Tesco Plc 2033 4.824 1.248 3.576 0.21 0.22
GE 2033 1.88 1.248 0.632 0.21 0.22
Proctor & Gamble 2033 1.786 1.248 0.538 0.2 0.22
HSBC Bank Plc 2033 3.485 1.248 2.237 0.21 0.22
Wessex Water 2033 2.114 1.248 0.866 0.19 0.22
Nestle 2033 0.899 1.248 -0.349 0.16 0.22
Glaxo 2033 1.927 1.248 0.679 0.2 0.22
Segro PLC 2035 2.512 1.401 1.111 0.19 0.22
Walmart 2035 2.028 1.401 0.627 0.2 0.22
Aviva Plc 2036 3.979 1.401 2.578 0.18 0.22
General Electric 2037 2.325 1.401 0.924 0.23 0.22
Lcr Financial Plc 2038 1.762 1.401 0.361 0.2 0.22
EIB 2039 1.64 1.401 0.239 0.2 0.22
Lloyds TSB 2040 2.693 1.495 1.198 0.2 0.22
GE 2040 2.114 1.495 0.619 0.2 0.22
Direct Line 2042 6.738 1.495 5.243 0.06 0.22
Barclays Bank Plc 2049 3.706 1.4 2.306 0.1 0.22

Source: Fixed Income Investor, Investing.com

The spread between international issuers such as Nestle – which, being Swiss, trades at a discount to Gilts – narrowed, however, higher yielding names, such as Direct Line, did likewise.

For comparison the table below – using the issues in bold from the table above – shows the change between the 22nd and 23rd June – pre and post-Brexit:-

Maturity Gilts 22-6 Corporate 22-6 Gilts 23-6 Corporate 23-6 Issuer Spread 22-6 Spread 23-6 Spread change
10y 1.314 4.18 1.396 4.68 Barclays 2.866 3.284 0.418
15y 1.879 3.86 1.96 3.88 Vodafone 1.981 1.92 -0.061
20y 2.065 4.76 2.124 4.78 Aviva 2.695 2.656 -0.039
25y 2.137 3.42 2.195 3.43 Lloyds 1.283 1.235 -0.048
30y 2.149 4.21 2.229 4.23 Barclays 2.061 2.001 -0.06

Source: Fixed Income Investor, Investing.com

Apart from a sharp increase in the yield on the 10yr Barclays issue (the 30yr did not react in the same manner) the spread between Gilts and corporates narrowed over the Brexit debacle too. This might be because bid/offer spreads in the corporate market became excessively wide – Gilts would have become the only realistic means of hedging – but the closing prices of the corporate names should have reflected mid-market yields.

If the “safe-haven” of Gilts has lost its lustre where should one invest? With patience and in higher yielding bonds – is one answer. Here is another from Ben Lord of M&G’s Bond Vigilantes – The BoE and ECB render the US bond market the only game in town:-

…The ultra-long conventional gilt has returned a staggering 52% this year. Since the result of the referendum became clear, the bond’s price has increased by 20%, and in the couple of weeks since Mark Carney announced the Bank of England’s stimulus package, the bond’s price has risen by a further 13%.

…the 2068 index-linked gilt, which has seen its price rise by 57% year-to-date, by 35% since the vote to exit Europe, and by 18% since further quantitative easing was announced by the central bank. Interestingly, too, the superior price action of the index-linked bond has occurred not as a result of rising inflation or expectations of inflation; instead it has been in spite of significantly falling inflation expectations so far this year. The driver of the outperformance is solely due to the much longer duration of the linker. Its duration is 19 years longer than the nominal 2068 gilt, by virtue of its much lower coupon!

When you buy a corporate bond you don’t just buy exposure to government bond yields, you also buy exposure to credit risk, reflected in the credit spread. The sterling investment grade sector has a duration of almost 10 years, so you are taking exposure to the 10 year gilt, which has a yield today of circa 0.5%. If we divide the yield by the bond’s duration, we get a breakeven yield number, or the yield rise that an investor can tolerate before they would be better off in cash. At the moment, as set out above, the yield rise that an investor in a 10 year gilt (with 9 year’s duration) can tolerate is around 6 basis points (0.5% / 9 years duration). Given that gilt yields are at all-time lows, so is the yield rise an investor can take before they would be better off in cash.

We can perform the same analysis on credit spreads: if the average credit spread for sterling investment grade credit is 200 basis points and the average duration of the market is 10 years, then an investor can tolerate spread widening of 20 basis points before they would be better off in cash. When we combine both of these breakeven figures, we have the yield rise, in basis points, that an investor in the average corporate bond or index can take before they should have been in cash.

With very low gilt yields and credit spreads that are being supported by coming central bank buying, accommodative policy and low defaults, and a benign consumption environment, it is no surprise that corporate bond yield breakevens are at the lowest level we have gathered data for. It is for these same reasons that the typical in-built hedge characteristic of a corporate bond or fund is at such low levels. Traditionally, if the economy is strong then credit spreads tighten whilst government bond yields sell off, such as in 2006 and 2007. And if the economy enters recession, then credit spreads widen and risk free government bond yields rally, such as seen in 2008 and 2009.

With the Bank of England buying gilts and soon to start buying corporate bonds, with the aim of loosening financial conditions and providing a stimulus to the economy as we work through the uncertain Brexit process and outcome, low corporate bond breakevens are to be expected. But with Treasury yields at extreme high levels out of gilts, and with the Fed not buying government bonds or corporate bonds at the moment, my focus is firmly on the attractive relative valuation of the US corporate bond market.

The table below shows a small subset of liquid US corporate bonds, showing the yield change between the 7th and 12th September:-

Issuer Issue Yield Maturity Change 7th to 12th Spread Rating
Home Depot HD 2.125 9/15/26 c26 2.388 10y 0.17 0.72 A2
Toronto Dominion TD 3.625 9/15/31 c 3.605 15y 0.04 1.93 A3
Oracle ORCL 4.000 7/15/46 c46 3.927 20y 0.14 1.54 A1
Microsoft MSFT 3.700 8/8/46 c46 3.712 20y 0.13 1.32 Aaa
Southern Company SO 3.950 10/1/46 c46 3.973 20y 0.18 1.58 Baa2
Home Depot HD 3.500 9/15/56 c56 3.705 20y 0.19 1.31 A2
US Treasury US10yr 1.67 10y 0.13 N/A AAA
US Treasury US30y 2.39 30y 0.16 N/A AAA

Source: Market Axess, Investing.com

Except for Canadian issuer Toronto Dominion, yields moved broadly in tandem with the T-Bond market. The spread between US corporates and T-Bonds may well narrow once the Fed gains a mandate to buy corporate securities, but, should Fed negotiations with Congress prove protracted, the cost of FX hedging may negate much of the benefit for UK or European investors.

What is apparent, is that the “flight to quality” effect is diminished even in the more liquid and higher yielding US market.

The total market capitalisation of the UK corporate bond market is relatively small at £285bln, the US market is around $4.5trln and Europe is between the two at Eur1.5trln. The European Central Bank (ECB) began its Corporate Sector Purchase Programme (CSPP) earlier this summer but delegated the responsibility to the individual National Banks.

Between 8th June and 15th July Europe’s central banks purchased Eur10.43bln across 458 issues. The average position was Eur22.8mln but details of actual holdings are undisclosed. They bought 12 issues of Deutsche Bahn (DBHN) 11 of Telefonica (TEF) and 10 issues of BMW (BMW) but total exposures are unknown. However, as the Bond Vigilantes -Which corporate bonds has the ECB been buying? point out, around 36% of all bonds eligible for the CSPP were trading with negative yields. This was in mid-July, since then 10y Bunds have fallen from -012% to, a stellar, +0.3%, whilst Europe’s central banks have acquired a further Eur6.71bln of corporates in August, taking the mark-to-market total to Eur19.92bln. The chart below shows the breakdown of purchases by country and industry sector at the 18th July:-

which-corporate-bonds-ecb3

Source: M&G Investments, ECB, Bloomberg

Here is the BIS data for total outstanding financial and non-financial debt as at the end of 2015:-

Country US$ Blns
France 2053
Spain 1822
Netherlands 1635
Germany 1541
Italy 1023
Luxembourg 858
Denmark 586

Source: BIS

In terms of CSPP holdings, Germany appears over-represented, Spain and the Netherlands under-represented. The “devil”, as they say, is in the “detail” – and a detailed breakdown by issuer, issue and size of holding, has not been published. The limited information is certainly insufficient for traders to draw any clear conclusions about which issues to buy or sell. As Wolfgang Bauer, the author of the M&G article, concludes:-

But as tempting as it may be to draw conclusions regarding over- and underweights and thus to anticipate the ECB’s future buying activity, we have to acknowledge that we are simply lacking data. Trying to “front run” the ECB is therefore a highly difficult, if not impossible task.

 Conclusions and investment opportunities

Back in May the Wall Street Journal published the table below, showing the change in the portfolio mix required to maintain a 7.5% return between 1995 and 2015:-

Source: Wall Street Journal, Callan Associates

The risk metric they employ is volatility, which in turn is derived from the daily mark-to-market price. Private Equity and Real-Estate come out well on this measure but are demonstrably less liquid. However, this table also misses the point made at the beginning of this letter – that “risk-free” assets are encumbered with much higher “capital” risk in a ZIRP to NIRP world. The lower level of volatility associated with bond markets disguises an asymmetric downside risk in the event of yield “normalisation”.

Dividends

Corporates with strong cash flows and rising earnings are incentivised to issue debt either for investment or to buy back their own stock; thankfully, not all corporates and leveraging their balance sheets. Dividend yields are around the highest they have been this century:-

dididend-yld-sandp

Source: Multpl.com

Meanwhile US Treasury Bond yields hit their lowest ever in July. Below is a sample of just a few higher yielding S&P500 stocks:-

Stock Ticker Price P/E Beta EPS DPS Payout Ratio Yield
At&t T 39.97 17.3 0.56 2.3 1.92 83 4.72
Target TGT 68.94 12.8 0.35 5.4 2.4 44 3.46
Coca-cola KO 42.28 24.3 0.73 1.7 1.4 80 3.24
Mcdonalds MCD 114.73 22.1 0.61 5.2 3.56 69 3.07
Procter & Gamble PG 87.05 23.6 0.66 3.7 2.68 73 3.03
Kimberly-clark KMB 122.39 22.8 0.61 5.4 3.68 68 2.98
Pepsico PEP 104.59 29.5 0.61 3.6 3.01 85 2.84
Wal-mart Stores WMT 71.46 15.4 0.4 4.6 2 43 2.78
Johnson & Johnson JNJ 117.61 22.1 0.43 5.3 3.2 60 2.69

Source: TopYield.nl

The average beta of the names above is 0.55 – given that the S&P500 has an historic volatility of around 15%, this portfolio would have a volatility of 8.25% and an average dividend yield of 3.2%. This is not a recommendation to buy an equally weighted portfolio of these stocks, merely an observation about the attractiveness of returns from dividends.

Government bonds offer little or no return if held to maturity – it is a traders market. For as long as central banks keep buying, bond prices will be supported, but, since the velocity of the circulation of money keeps falling, central banks are likely to adopt more unconventional policies in an attempt to transmit stimulus to the real economy. If the BoJ, BoE and ECB are any guide, this will lead them (Fed included) to increase purchases of corporate bonds and even common stock.

Bond bear-market?

Predicting the end of the bond bull-market is not my intention, but if central banks should fail in their unconventional attempts at stimulus, or if their mandates are withdrawn, what has gone up the most (government bonds) is likely to fall farthest. At some point, the value of owning “risk-free” assets will reassert itself, but I do not think a 1% rise in yields will be sufficient. High yielding stocks from companies with good dividend cover, low betas and solid cash flows, will weather the coming storm. These stocks may suffer substantial corrections, but their businesses will remain intact. When the bond bubble finally bursts “risky” assets may be safer than conventional wisdom suggests. The breakdown in the “flight to quality” effect is just one more indicator that the rules of engagement are changing.