Equity valuation in a de-globalising world


Macro Letter – No 68 – 13-01-2017

Equity valuation in a de-globalising world

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

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

US Stocks and the Yield Gap

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


Source: Reuters

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

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


Source: Multpl, St Louis Federal Reserve

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

S&P 500 forecasts for 2017

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

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

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

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

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

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

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

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

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

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

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

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


Source: Trading Economics, Institute for Supply Management

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


Source: Yardeni, Citigroup

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

Global Stocks

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

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

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

Source: Investment Frontier

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

Industry Sectors

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

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

Source: Star Capital

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

Developed Market Opportunities

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

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

Source: Star Capital, Bloomberg, Reuters

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

Value Investing

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

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

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


Source: MSCI, Bloomberg

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

Conclusion and Investment Opportunities

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

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

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

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

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

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

Is the “flight to quality” effect breaking down?


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:-


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:-


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”.


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:-


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.

Drowning in debt


Macro Letter – No 60 – 02-09-2016

Drowning in debt

  • Central Banks are moving from quantitative to qualitative easing
  • The spread between Investment Grade and Government bond yields is narrowing
  • Issuing corporate debt rather than equity has never been so attractive
  • Corporate leverage is rising, share buy-backs continue but investment remains weak

I was always

Far out at sea

And not waving

But drowning

Stevie Smith

During August the financial markets have been relatively quiet, however, the Bank of England (BoE) cut interest rates on 4th and added Investment Grade Corporate bonds to their Asset Purchase Programme. The following day Vodafone (VOD) issued a 40yr bond yielding 3% – a week earlier they had issued a 33yr bond yielding 3.4%.

Meanwhile, at Jackson Hole the Kansas City Federal Reserve Symposium discussed a paper by Professor Jeremy Stein – a member Federal Reserve board member between 2012 and 2014 – and two other Harvard professors entitled The Federal Reserve Balance Sheet as a Financial Stability Tool – in which the authors argue that the Fed should maintain its balance sheet at around $4.5trln but that it “should use its balance sheet to lean against private-sector maturity transformation.” In layman’s terms this is a “call to arms” encouraging the Fed to seek approval from the US government to allow the purchase a much wider range of corporate securities. It would appear that the limits of central bank omnipotence have yet to be reached. The Bank of Japan has already begun to discover the unforeseen effect that negative interest rate policy has on the velocity of the circulation of money – it collapses. Now central bankers, who’s credibility has begun to be questioned in some quarters of late, are considering the wider use of “qualitative” measures.

As Bastiat has taught us, that which is seen from these policies is a reduction in the cost of borrowing for “investment grade” corporations. What is not seen, so clearly, is the incentive corporates have to borrow, not to invest, but to buy back their own stock. Perhaps I am being unfair, but, in a world which is drowning in debt, central bankers seem to think that the over-indebted are not “drowning” but “waving”.

One of the most cherished ideas, promulgated upon an unsuspecting world, is the concept of using fiscal and monetary stimulus to offset cyclical economic downturns. The aim of these “popular” policies is to soften the blow of economic slowdowns – all highly laudable provided the “punch bowl” is withdrawn during the cyclical recovery.

So much for business cycles: but what about the impact these policies may have on structural changes in economic performance relating to supply and demand for factors of production, such as labour, fixed assets or basic materials? I’m thinking here about the impact, especially, of technology and demographics.

Firstly, the cyclical stimulus extended during the downturn is seldom withdrawn during the upturn and secondly, long term structural changes in economies are seldom considered by governments, since these changes evolve over decades or generations, rather than the span of a single parliament. This is an essential weakness in the democratic process which has stifled economic growth for centuries. This excellent paper from Carmen M. Reinhart, Vincent R. Reinhart, and Kenneth S. Rogoff – The Journal of Economic Perspectives – Volume 26 – No 3 – Summer 2012 – Public Debt Overhangs: Advanced Economy Episodes Since 1800 makes this weakness abundantly clear.

The authors expand on their earlier research, this time looking at the impact of excessive public debt overhang on economic growth. They take as their “line in the sand” the point where the government debt to nominal GDP ratio remains above 90% for more than five years. They identify 26 episodes, 20 of which lasted more than a decade – the average was 23 years. It is worth noting that more than one third of these episodes occurred without interest rates rising above normal levels.

In 23 of the 26 episodes, over the 211 year sample, the pace of economic growth was lowered from 3.5% to 2.3% – in other words GDP was reduced by roughly one third. The long term secular impact of high debt and lower growth needs to be weighed against the short-term benefits of Keynesian stimulus. A lowering of the GDP growth rate of 1.2% for 23 years is equivalent to a 24.25% reduction in the potential size of the economy at the end of the debt overhang period – a tall price for any economy to pay.

The authors briefly examine the other types of outstanding debt, in order to arrive at what they dub “the quadruple debt overhang problem”, namely, private debt, external debt (and its associated currency risks) and the “actuarial” debt implicit in “unfunded” pension schemes and medical insurance programmes. This data is hard to untangle but the authors state:-

…the overall magnitude of the debt burdens facing the advanced economies as a group is in many dimensions without precedent. The interaction between the different types of debt overhang is extremely complex and poorly understood, but it is surely of great potential importance.

The 22 developed economies in their sample are now burdened with debt to GDP ratios above the levels seen in the aftermath of WWII. Their 48 emerging market counterparts had their epiphany in the debt crisis of the mid 1980’s, since when they have assumed a certain sobriety of character. This shows up even more glaringly in the divergence since 1986 in the public, plus private, external debt. In developed countries it has risen from around 75% of GDP to more than 250% whilst emerging economies external debt has fallen from a broadly similar 75% to less than 50% today. Governments, often bailout private external debt holders in order to protect the stability of their currencies.

Private domestic credit is another measure of total indebtedness which the authors analyse. For the 48 emerging economies this has remained constant at around 40% of GDP since the mid-1980s whilst in the developed 22 it has risen from 50% in the 1950’s to above 150% today. Since the bursting of the technology stock bubble in 2000 this trend has accelerated but the authors point out that these increases are often caused by cross border capital inflows.

The rise in the debt to GDP ratio may come from a slowing in growth rather than an increase in government debt but the correlation between rising debt and slowing GDP rises dramatically as the ratio exceeds 90%.

The authors draw the following conclusions:-

…First, once a public debt overhang has lasted five years, it is likely to last 10 years or much more (unless the debt was caused by a war that ends).

…it is quite possible to have a “no drama” public debt overhang, which doesn’t involve a rise in real interest rates or a financial crisis. Indeed, in 11 of our 26 public debt overhang episodes, real interest rates were on average comparable, or lower, than at other times.

…Another line of reasoning for dismissing concerns about public debt overhangs is the view that causality mostly runs from growth to debt. However, we discussed a body of evidence which argues runs from growth to debt. However, we discussed a body of evidence which argues that causality does indeed run from the public debt overhang to slower growth. There are counterexamples where a public debt overhang was accompanied by rapid growth, like the immediate period after World War II for the United States and United Kingdom, but these exceptions to the typical pattern do not seem to be the most relevant parallels for the modern world economy.

…The pathway to containing and reducing public debt will require a change that is sustained over the middle and the long term. However, the evidence, as we read it, casts doubt on the view that soaring government debt does not matter when markets (and official players, notably central banks) seem willing to absorb it at low interest rates—as is the case for now.

The Methadone of the Markets

The bull market in fixed income securities began in the early 1980’s. The price of “risk free” assets has always had a significant influence on the valuation of equities but, since the advent of quantitative easing, the principle driver of performance has become the level of interest rates. As the yield on fixed income securities has inexorably declined the spread between the dividend and bond yield has returned to positive territory after many years of inversion.

Companies with growing earnings from their operations can finance more cheaply than at any time in history. Provided they can sustain their growth, their bonds should, theoretically, begin to trade at a discount to government bonds. This would probably have happened before now had the central banks not embarked on quantitative easing revolving around the purchase of government bonds at already artificially inflated prices. The rules on capital weighting which favour “risk free” assets and regulations requiring pension funds and other financial institutions to hold minimum levels of “risk free” assets has further distorted the marketplace.

The unfunded government pension schemes of developed nations are at the mercy of the demographic headwind of a smaller working age population supporting a growing legion of retirees. Added to which, breakthroughs in medical science suggest that actuarial expectations of life expectancy may once again be underestimated.

Ways out of debt

There are a number of solutions other than fiscal austerity. For example, increasing the pensionable age steadily towards the average life expectancy. This may sound extreme but in January 1909, when the pension was first introduced in the UK, the pensionable age was 70 years and life expectancy was 50 years for men and 53.5 for women. The latest ONS data shows male life expectancy at 79 years whilst for females it is 82.8 years. The pensionable age for women has now risen to 63 years and will be brought in line with men (65 years) by 2018. There is still a long way to go, by 2030 the NHS estimate the male average will be 85.7 years, with females living an average of 87.6 years. Meanwhile the pensionable age will reach 68 years by 2028. In other words, the current, deeply unpopular, proposed increase in the pensionable age is barely keeping pace with the projected increase in life expectancy.

Another solution which would help to reduce the level of public debt is a structural policy of capping government spending at less than 40% of GDP. This could be relaxed to less than 50% during recessions as a temporary counter-cyclical measure. UK GDP averaged 2.47% since 1953 – if government spending only increased slightly less than 1% per annum we could steadily reduce the public sector debt burden towards a manageable 30% level over the next 40 years, after all, as recently as 2005 the ratio of government debt to GDP was at 38%. The chart below of the Rahn Curve shows the optimal ratio of government debt to GDP. Once government spending exceeds 15% it acts as a drag on the potential growth of an economy:-


Source: The Heritage Foundation, Peter Brimelow

The interest paid on corporate debt and bank loans is tax deductible which creates an incentive to issue debt rather than equity. It is difficult to change this situation but mandating that equity may only be retired from after-tax profits would encourage leverage for investment purposes rather than to artificially enhance the return on equity. The chart below shows the decline in net domestic investment in the US despite historically low interest rates:-

fredgraph (1)

Source: Federal Reserve Bank of St Louis

The next chart shows the level of share buybacks and the performance of the S&P500:-


Source: Dent Research, S&P, Haver Analytics, Barclays Research, Business Insider

Household debt is predominantly in the form of mortgages. In most developed countries a shortage of housing stock, due to planning restrictions, has encouraged individuals to speculate in the real estate market. In fact BoE Chief Economist Andy Haldane was quoted in The Sunday Times – Property is a better bet than pensions, says gold-plated Bank guru stating that pensions were complex and housing was a better investment:-

As long as we continue not to build anything like as many houses in this country as we need to … we will see what we’ve had for the better part of a generation, which is house prices relentlessly heading north.

The solution is planning reform. This will reduce house price inflation but it will not reduce the level of mortgage debt, however, once housing ceases to be a “one way bet” the attraction of leveraged speculation in property will diminish.

Conclusions and Investment Opportunities

The underlying problem which caused the great recession of 2009/2010 was excessive debt. The policy response has been to throw petrol on the fire. The first phase of unconventional monetary policy – reducing official interest rates towards zero – has more or less run its course. The next phase – qualitative easing – is now under way. This will start with corporate bonds and proceed to other securities ending up with common stock. Credit spreads will continue to narrow even if government bond yields rise. There will, of course, be episodes of panic when “safe haven” government bonds outperform but this will be temporary and the spread widening will present a buying opportunity.

The UK Investment Grade bond market is relatively small at £285bln and liquidity is therefore less robust than for Euro or US$ denominated issues but there is a £10bln “put” beneath the market. Other initiatives will be forthcoming from the central banks. Their actions will continue to be the dominant factor influencing asset prices in general.

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


Macro Letter – No 53 – 22-04-2016

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

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

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

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

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

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

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

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

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

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

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

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

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


Source: PFS Group, Bloomberg

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


Source: Acting Man

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

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

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


Source: Global Property Guide, Federal Housing Finance Agency

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

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

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

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

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

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

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

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

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

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


Source: Bloomberg, Financial Sense

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

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

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


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

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

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

US CAPEX by sector

Source: Business Insider, Compustat, Goldman Sachs

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

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

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

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

Source: McGraw Hill

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

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

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

Quantitative to qualitative – is unelected nationalisation next?


Macro Letter – No 52 – 08-04-2016

Quantitative to qualitative – is unelected nationalisation next?

  • Negative interest rates are reducing the velocity of circulation
  • Qualitative easing is on the rise
  • Liquidity in government bond markets continues to decline
  • A lack of liquidity in equity markets will be next

Last year, in a paper entitled The Stock Market Crash Really Did Cause the Great Recession – Roger Farmer of UCLA argued that the collapse in the stock market was the cause of the Great Recession:-

In November of 2008 the Federal Reserve more than doubled the monetary base from eight hundred billion dollars in October to more than two trillion dollars in December: And over the course of 2009 the Fed purchased eight hundred billion dollars worth of mortgage backed securities. According to the animal spirits explanation of the recession (Farmer, 2010a, 2012a,b, 2013a), these Federal Reserve interventions in the asset markets were a significant factor in engineering the stock market recovery.

The animal spirits theory provides a causal chain that connects movements in the stock market with subsequent changes in the unemployment rate. If this theory is correct, the path of unemployment depicted in Figure 8 is an accurate forecast of what would have occurred in the absence of Federal Reserve intervention. These results support the claim, in the title of this paper, that the stock market crash of 2008 really did cause the Great Recession.

Central banks (CBs) around the globe appear to concur with his view. Their response to the Great Recession has been the provision of abundant liquidity – via quantitative easing – at ever lower rates of interest. They appear to believe that the recovery has been muted due to the inadequate quantity of accommodation and, as rates drift below zero, its targeting.

The Federal Reserve (Fed) was the first to recognise this problem, buying mortgages as well as Treasuries, perhaps guided by the US Treasury’s implementation of TARP in October 2008. The Fed was fortunate in being unencumbered by the political grid-lock which faced the European Central Bank (ECB). They acted, aggressively and rapidly, hoping to avoid the policy mistakes of the Bank of Japan (BoJ). The US has managed to put the great recession behind it. But at what cost? Only time will tell.

Other major CBs were not so decisive or lucky. In the immediate aftermath of the sub-prime crisis the Swiss Franc (CHF) rose – a typical “safe-haven” reaction. The SNB hung on grimly as the CHF appreciated, especially against the EUR, but eventually succumbed to “the peg” in September 2011 after the Eurozone (EZ) suffered its first summer of discontent. It was almost a year later before ECB President Draghi uttered his famous “Whatever it takes” speech on 26th July 2012.

Since 2012 government bond yields in the EZ, Switzerland, Japan and the UK have fallen further. In the US yields recovered until the end of 2013 but have fallen once more as international institutions seek yield wherever they can.

By 2013 CBs had begun to buy assets other than government bonds as a monetary exercise, in the hope of simulating economic growth. Even common stock became a target, since they were faced with the same dilemma as other investors – the need for yield.

In late April 2013 Bloomberg – Central Banks Load Up on Equities observed:-

Central banks, guardians of the world’s $11 trillion in foreign-exchange reserves, are buying stocks in record amounts as falling bond yields push even risk-averse investors toward equities.

In a survey of 60 central bankers…23 percent said they own shares or plan to buy them. The Bank of Japan, holder of the second-biggest reserves, said April 4 it will more than double investments in equity exchange-traded funds to 3.5 trillion yen ($35.2 billion) by 2014. The Bank of Israel bought stocks for the first time last year while the Swiss National Bank and the Czech National Bank have boosted their holdings to at least 10 percent of reserves.

…The SNB allocated 82 percent of its 438 billion Swiss francs ($463 billion) in reserves to government bonds in the fourth quarter, according to data on its website. Of those securities, 78 percent had the top, AAA credit grade and 17 percent were rated AA.

…The survey of 60 central bankers, overseeing a combined $6.7 trillion, found that low bond returns had prompted almost half to take on more risk. Fourteen said they had already invested in equities or would do so within five years.

…Even so, 70 percent of the central bankers in the survey indicated that equities are “beyond the pale.”

the SNB has allocated about 12 percent of assets to passive funds tracking equity indexes. The Bank of Israel has spent about 3 percent of its $77 billion reserves on U.S. stocks.

…the BOJ announced plans to put more of its $1.2 trillion of reserves into exchange-traded funds this month as it doubled its stimulus program to help reflate the economy. The Bank of Korea began buying Chinese shares last year, increasing its equity investments to about $18.6 billion, or 5.7 percent of the total, up from 5.4 percent in 2011. China’s foreign-exchange regulator said in January it has sought “innovative use” of its $3.4 trillion in assets, the world’s biggest reserves, without specifying a strategy for investing in shares.

Reserves have increased at a slower pace since 2012, but the top 50 countries still accounted for $11.4trln, according to the latest CIA Factbook estimates. The real growth has been in emerging and developing countries – according to IMF data, since 2000, in the wake of the Asian crisis, their reserves grew from $700bln to above $8trln.

By June 2014 the Financial Times – Beware central banks’ share-buying sprees was sounding the alarm:-

An eye-catching report this week said that “a cluster of central banking investors has become major players on world equity markets”. An important driver was revenues foregone on bond portfolios.

Put together by the Official Monetary and Financial Institutions Forum, which brings together secretive and normally conservative central bankers, the report’s conclusions have authority. Some equity buying was in central banks’ capacity as, in effect, sovereign wealth fund managers. China’s State Administration of Foreign Exchange, which has $3.9tn under management, has become the world’s largest public sector holder of equities.

The boundary, however, with monetary policy making is not always clear. According to the Omfif report, China’s central bank itself “has been buying minority equity stakes in important European companies”.

…Central bank purchases of shares are not new. The Dutch central bank has invested in equities for decades. The benchmark for its €1.4bn portfolio is the MSCI global developed markets index.

The Italian, Swiss and Danish central banks also own equities. Across Europe, central banks face pressures from cash-strapped governments to boost income. As presumably cautious and wise investors, they have also been put in charge of managing sovereign wealth funds – Norway’s, for instance.

…the Hong Kong Monetary Authority launched a large-scale stock market intervention in 1998, splashing out about $15bn – and ended up making a profit. Since the Asian financial crisis of that year, official reserves have expanded massively – far beyond what might be needed in future financial crises or justified by trade flows.

The article goes on to state that CB transparency is needed and that it should be made clear whether the actions are monetary policy or investment activity. Equities are generally more volatile than bonds – losses could lead to political backlash, or worse still, undermine the prudent reputation of the CB itself.

Here is an example of just such an event, from July last year, as described by Zero Hedge – The Swiss National Bank Is Long $94 Billion In Stocks, Reports Record Loss Equal To 7% Of Swiss GDP:-

…17%, or CHF91 ($94 billion) of the foreign currency investments and CHF bond investments assets held on the SNB’s balance sheet are foreign stocks…

In other words, the SNB holds 15% of Switzerland’s GDP in equities!

Zero Hedge goes on to remonstrate against the lack of transparency of other CBs equity investment balances – in particular the Fed.

The ECB, perhaps due to its multitude of masters, appears reluctant to follow the lead of the SNB. In March 2015 it achieved some success by announcing that it would buy Belgian, French, Italian and Spanish bonds, under its QE plan, in addition to those of, higher rated, Finland, Germany, Luxembourg and the Netherlands. EZ Yield compression followed with Italy and Spain benefitting most.

The leading exponent of this “new monetary alchemy” is the BoJ. In an October 2015 report from Bloomberg – Owning Half of Japan’s ETF Market Might Not Be Enough for Kuroda the author states:-

With 3 trillion yen ($25 billion) a year in existing firepower, the BOJ has accumulated an ETF stash that accounted for 52 percent of the entire market at the end of September, figures from Tokyo’s stock exchange show.

…Japan’s central bank began buying ETFs in 2010 to spur more trading and promote “more risk-taking activity in the overall economy.” Governor Haruhiko Kuroda expanded the program in April 2013 and again last October.

BoJ ETF holdings - October 2015 - Bloomberg

Source: Bloomberg, TSE

More ETFs can be created to redress the balance, or the BoJ may embark on the purchase of individual stocks. They announced a small increase in ETF purchases in December, focused on physical and human capital firms – also advising that shares they bought from distressed financial institutions in 2002 will be sold (very gradually) at the rate of JPY 300bln per annum over the next decade. At the end of January the BoJ decided to adopt negative interest rate policy (NIRP) rather than expand ETF and bond purchases – this saw the Nikkei hit its lowest level since October 2014 whilst the JYP shed more than 8% against the US$. I anticipate that they will soon increase their purchases of ETFs or stocks once more. The NIRP decision was half-hearted and BoJ concerns, about corporates and individuals resorting to cash stashed in safes, may prove well founded – So it begins…Negative Interest rates Trickle Down in Japan – Mises.org discusses this matter in greater detail.

In early March the ECB acted with intent, CNBC – ECB pulls out all the stops, cuts rates and expands QE takes up the story:-

…the ECB announced on Thursday that it had cut its main refinancing rate to 0.0 percent and its deposit rate to minus-0.4 percent.

“While very low or even negative inflation rates are unavoidable over the next few months as a result of movement in oil prices, it is crucial to avoid second-round effects,” Draghi said in his regular media conference after the ECB statement.

The bank also extended its monthly asset purchases to 80 billion euros ($87 billion), to take effect in April.

…the ECB will add corporate bonds to the assets it can buy — specifically, investment grade euro-denominated bonds issued by non-bank corporations. These purchases will start towards end of the first half of 2016.

…the bank will launch a new series of four targeted longer-term refinancing operations (TLTROs) with maturities of four years, starting in June.

The Communique from the G20 meeting in Shanghai alluded to the need for increased international cooperation, but it appears that a sub-rosa agreement may have been reached to insure the Chinese did not devalue the RMB – in return for a cessation of monetary tightening by the Fed.

In an unusually transparent move, a report appeared on March 31st on Reuters – China forex regulator buys $4.2 bln in stocks via new platform:-

Buttonwood Investment Platform Ltd, 100 percent owned by the State Administration of Foreign Exchange (SAFE), and Buttonwood’s two fully-owned subsidiaries, have bought shares in a total of 13 listed companies, the newspaper reported, citing top 10 shareholder lists in the companies latest earnings reports.

Shanghai Securities News said the investments are part of SAFE’s strategy to diversify investment channels for the country’s massive foreign exchange reserves.

Recent earnings filings show Buttonwood is among the top 10 shareholders of Bank of China, Bank of Communications , Shanghai Pudong Development Bank , Everbright Securities and Industrial and Commercial Bank of China.

Conclusions and investment opportunities

The major CBs are beginning to embrace the idea of providing capital to corporates via bond or stock purchases. With next to no yield available from government bonds, corporate securities appear attractive, especially when one has the ability to expand ones balance sheet, seemingly, without limit.

The CBs are unlikely to buy when the market is strong but will provide liquidity in distressed markets. Once they have purchased securities the “free-float” will be almost permanently reduced. The lack of, what might be termed, “trading liquidity”, which has been evident in government bond markets, is likely to spill over into those corporate bonds and ETFs where the CBs hold a significant percentage. In the UK, under our takeover code, a 30% holding in a stock would obligate the holder to make an offer for the company – the 52% of outstanding ETFs held by the BoJ already seems excessive.

The ECB has plenty of government, agency and corporate bonds to purchase, before it moves on to provide permanent equity capital. The BoE and the Fed are subject to less deflationary forces; they will be the last guests to arrive at the “closet nationalisation” party. The party, nonetheless, is getting underway. Larger companies will benefit to a much greater extent than smaller listed or unlisted corporations because the CBs want to appear to be “indiscriminate” buyers of stock.

As the pool of available bonds and stocks starts to dry up, trading liquidity will decline – markets will become more erratic and volatile. Of greater concern in economic terms, malinvestment will increase; interest rates no longer provide signals about the value of projects.

For stocks, higher earning multiples are achievable due to the rising demand for equities from desperate investors with no viable “yield” alternative. CBs are unelected stewards on whom elected governments rely with increasing ease. For notionally independent CBs to purchase common stock is de facto nationalisation. The economic cost of an artificially inflated stock market is difficult to measure in conventional terms, but its promotion of wealth inequality through the sustaining of asset bubbles will do further damage to the fabric of society.

Central Banks – Ah Aaaaahhh! – Saviours of the Universe?


Macro Letter – No 48 – 29-01-2016

Central Banks – Ah Aaaaahhh! – Saviours of the Universe?


Copryright: Universal Pictures

  • Freight rates have fallen below 2008 levels
  • With the oil price below $30 many US producers are unprofitable
  • The Fed has tightened but global QE gathers pace
  • Chinese stimulus is fighting domestic strong headwinds

Just in case you’re not familiar with it here is a You Tube video of the famous Queen song. It is seven years since the Great Financial Crisis; major stock markets are still relatively close to their highs and major government bond yields remain near historic lows. If another crisis is about to engulf the developed world, do the central banks (CBs) have the means to avert catastrophe once again? Here are some of the factors which may help us to reach a conclusion.

Freight Rates

Last week I was asked to comment of the prospects for commodity prices, especially energy. Setting aside the geo-politics of oil production, I looked at the Baltic Dry Index (BDI) which has been plumbing fresh depths this year – 337 (28/1/16) down from August 2015 highs of 1200. Back in May 2008 it touched 11,440 – only to plummet to 715 by November of the same year. How helpful is the BDI at predicting the direction of the economy? Not very – as this 2009 article from Business Insider – Shipping Rates Are Lousy For Predicting The Economy – points out. Nonetheless, the weakness in freight rates is indicative of an inherent lack of demand for goods. The chart below is from an article published by Zero Hedge at the beginning of January – they quote research from Deutsche Bank.

BDI_-_1985_-_2016 (4)

Source: Zerohedge

A “Perfect Storm Is Coming” Deutsche Warns As Baltic Dry Falls To New Record Low:

…a “perfect storm” is brewing in the dry bulk industry, as year-end improvements in rates failed to materialize, which indicates a looming surge in bankruptcies.

The improvement in dry bulk rates we expected into year-end has not materialized.

…we believe a number of dry bulk companies are contemplating asset sales to raise liquidity, lower daily cash burn, and reduce capital commitments. The glut of “for sale” tonnage has negative implications for asset and equity values. More critically, it can easily lead to breaches in loan-to-value covenants at many dry bulk companies, shortening the cash runway and likely necessitating additional dilutive actions.

Dry bulk companies generally have enough cash for the next 1yr or so, but most are not well positioned for another leg down in asset values.


The slowing and rebalancing of the Chinese economy may be having a significant impact on global trade flows. Here is a recent article on the subject from Mauldin Economics – China’s Year of the Monkees:-

China isn’t the only reason markets got off to a terrible start this month, but it is definitely a big factor (at least psychologically). Between impractical circuit breakers, weaker economic data, stronger capital controls, and renewed currency confusion, China has investors everywhere scratching their heads.

When we focused on China back in August (see “When China Stopped Acting Chinese”), my best sources said the Chinese economy was on a much better footing than its stock market, which was in utter chaos. While the manufacturing sector was clearly in a slump, the services sector was pulling more than its fair share of the GDP load. Those same sources have new data now, which leads them to quite different conclusions.

…Now, it may well be the case that China’s economy is faltering, but its GDP data is not the best evidence.

…To whom can we turn for reliable data? My go-to source is Leland Miller and company at the China Beige Book.

…China Beige Book started collecting data in 2010. For the entire time since then, the Chinese economy has been in what Leland calls “stable deceleration.” Slowing down, but in an orderly way that has generally avoided anything resembling crisis. 

…China Beige Book noticed in mid-2014 that Chinese businesses had changed their behavior. Instead of responding to slower growth by doubling down and building more capacity, they did the rational thing (at least from a Western point of view): they curbed capital investment and hoarded cash. With Beijing still injecting cash that businesses refused to spend, the liquidity that flowed into Chinese stocks produced the massive rally that peaked in mid-2015. It also allowed money to begin to flow offshore in larger amounts. I mean really massively larger amounts.

Dealing with a Different China

China Beige Book’s fourth-quarter report revealed a rude interruption to the positive “stable deceleration” trend. Their observers in cities all over that vast country reported weakness in every sector of the economy. Capital expenditures dropped sharply; there were signs of price deflation and labor market weakness; and both manufacturing and service activity slowed markedly.

That last point deserves some comment. China experts everywhere tell us the country is transitioning from manufacturing for export to supplying consumer-driven services. So if both manufacturing and service activity are slowing, is that transition still happening?

The answer might be “yes” if manufacturing were decelerating faster than services. For this purpose, relative growth is what counts. Unfortunately, manufacturing is slowing while service activity is not picking up all the slack. That’s not the combination we want to see.

Something else China Beige Book noticed last quarter: both business and consumer loan volume did not grow in response to lower interest rates. That’s an important change, and probably not a good one. It means monetary stimulus from Beijing can’t save the day this time. Leland thinks fiscal stimulus isn’t likely to help, either. Like other governments and their central banks, China is running out of economic ammunition.

Mauldin goes on to discuss the devaluation of the RMB – which I also discussed in my last letter – Is the ascension of the RMB to the SDR basket more than merely symbolic? The RMB has been closely pegged to the US$ since 1978 though with more latitude since 2005, this has meant a steady appreciation in its currency relative to many of its emerging market trading partners. Now, as China begins to move towards full convertibility, the RMB will begin to float more freely. Here is a five year chart of the Indian Rupee and the CNY vs the US$:-

INR vs RMB - Yahoo

Source: Yahoo finance

The Chinese currency could sink significantly should their government deem it necessary, however, expectations of a collapse of growth in China may be premature as this article from the Peterson Institute – The Price of Oil, China, and Stock Market Herding – indicates:-

A collapse of growth in China would indeed be a world changing event. But there is just no evidence of such a collapse. At most there is suggestive evidence of a mild slowdown, and even that is far from certain. The mechanical effects of such a mild decrease on the US economy should, by all accounts, and all the models we have, be limited. Trade channels are limited (US exports to China represent less than 2 percent of GDP), and so are financial linkages. The main effect of a slowdown in China would be through lower commodity prices, which should help rather than hurt the United States.

Peterson go on to suggest:-

Maybe we should not believe the market commentaries. Maybe it was neither oil nor China. Maybe what we are seeing is a delayed reaction to the slowdown in the world economy, a slowdown that has now gone on for a few years. While there has been no significant news in the last two weeks, maybe markets are only realizing that growth in emerging markets will be lower for a long time, that growth in advanced economies will be unexciting. Maybe…

I think the explanation is largely elsewhere. I believe that to a large extent, herding is at play. If other investors sell, it must be because they know something you do not know. Thus, you should sell, and you do, and so down go stock prices. Why now? Perhaps because we have entered a period of higher uncertainty. The world economy, at the start of 2016, is a genuinely confusing place. Political uncertainty at home and geopolitical uncertainty abroad are both high. The Fed has entered a new regime. The ability of the Chinese government to control its economy is in question. In that environment, in the stock market just as in the presidential election campaign, it is easier for the bears to win the argument, for stock markets to fall, and, on the political front, for fearmongers to gain popularity.

They are honest enough to admit that economics won’t provide the answers.

Energy Prices

The June 2015 BP – Statistical Review of World Energy – made the following comments:-

Global primary energy consumption increased by just 0.9% in 2014, a marked deceleration over 2013 (+2.0%) and well below the 10-year average of 2.1%. Growth in 2014 slowed for every fuel other than nuclear power, which was also the only fuel to grow at an above-average rate. Growth was significantly below the 10-year average for Asia Pacific, Europe & Eurasia, and South & Central America. Oil remained the world’s leading fuel, with 32.6% of global energy consumption, but lost market share for the fifteenth consecutive year.

Although emerging economies continued to dominate the growth in global energy consumption, growth in these countries (+2.4%) was well below its 10-year average of 4.2%. China (+2.6%) and India (+7.1%) recorded the largest national increments to global energy consumption. OECD consumption fell by 0.9%, which was a larger fall than the recent historical average. A second consecutive year of robust US growth (+1.2%) was more than offset by declines in energy consumption in the EU (-3.9%) and Japan (-3.0%). The fall in EU energy consumption was the second-largest percentage decline on record (exceeded only in the aftermath of the financial crisis in 2009).

The FT – The world energy outlook in five charts – looked at five charts from the IEA World Energy Outlook – November 2015:-


Source: IEA

With 315m of its population expected to live in urban areas by 2040, and its manufacturing base expanding, India is forecast to account for quarter of global energy demand growth by 2040, up from about 6 per cent currently.


Source: IEA

Oil demand in India is expected to increase by more than in any other country to about 10m barrels per day (bpd). The country is also forecast to become the world’s largest coal importer in five years. But India is also expected to rely on solar and wind power to have a 40 per cent share of non-fossil fuel capacity by 2030.


Source: IEA

China’s total energy demand is set to nearly double that of the US by 2040. But a structural shift in the Asian country away from investment-led growth to domestic-demand based economy will “mean that 85 per cent less energy is required to generate each unit of future economic growth than was the case in the past 25 years.”


Source: IEA

US shale oil production is expected to “stumble” in the short term, but rise as oil price recovers. However the IEA does not expect crude oil to reach $80 a barrel until 2020, under its “central scenario”. The chart shows that if prices out to 2020 remain under $60 per barrel, production will decline sharply.


Source: IEA

Renewables are set to overtake coal to become the largest source of power by 2030. The share of coal in the production of electricity will fall from 41 per cent to 30 per cent by 2040, while renewables will account for more than half the increase in electricity generation by then.

The cost of solar energy continues to fall and is now set to “eclipse” natural gas, as this article from Seeking Alpha by Siddharth Dalal – Falling Solar Costs: End Of Natural Gas Is Near? Explains:-

A gas turbine power plant uses 11,371 Btu/kWh. The current price utilities are paying per Btu of natural gas are $3.23/1000 cubic feet. 1000 cubic feet of natural gas have 1,020,000 BTUs. So $3.23 for 90kWh. That translates to 3.59c/kWh in fuel costs alone.

A combined cycle power plant uses 7667 Btu/kWh, which translates to 2.42c/kWh.

Adding in operating and maintenance costs, we get 4.11c/kWh for gas turbines and 3.3c/kWh for combined cycle power plants. This still doesn’t include any construction costs.

…The average solar PPA is likely to go under 4c/kWh next year. Note that this is the total cost that the utility pays and includes all costs.

And the trend puts total solar PPA costs under gas turbine fuel costs and competitive with combined cycle plant total operating costs next year.

At this point it becomes a no brainer for a utility to buy cheap solar PPAs compared to building their own gas power plants.

The only problem here is that gas plants are dispatchable, while solar is not. This is a problem that is easily solved by batteries. So utilities would be better served by spending capex on batteries as opposed to any kind of gas plant, especially anything for peak generation.

The influence of the oil price, whilst diminishing, still dominates. In the near term the importance of the oil price on financial market prices will relate to the breakeven cost of production for companies involved in oil exploration. Oil companies have shelved more than $400bln of planned investment since 2014. The FT – US junk-rated energy debt hits two-decade lowtakes up the story:-

US-High Yield - Thompson Reuters

Source: Thomson Reuters Datastream, FT

The average high-yield energy bond has slid to just 56 cents on the dollar, below levels touched during the financial crisis in 2008-09, as investors brace for a wave of bankruptcies.

…The US shale revolution which sent the country’s oil production soaring from 2009 to 2015 was led by small and midsized companies that typically borrowed to finance their growth. They sold $241bn worth of bonds during 2007-15 and many are now struggling under the debts they took on.

Very few US shale oil developments can be profitable with crude at about $30 a barrel, industry executives and advisers say. Production costs in shale have fallen as much as 40 per cent, but that has not been enough to keep pace with the decline in oil prices.

…On Friday, Moody’s placed 120 oil and gas companies on review for downgrade, including 69 in the US.

…The yield on the Bank of America Merrill Lynch US energy high-yield index has climbed to the highest level since the index was created, rising to 19.3 per cent last week, surpassing the 17 per cent peak hit in late 2008.

More than half of junk-rated energy groups in the US have fallen into distress territory, where bond yields rise more than 1,000 basis points above their benchmark Treasury counterpart, according to S&P.

All other things equal, the price of oil is unlikely to rally much from these levels, but, outside the US, geo-political risks exist which may create an upward bias. Many Middle Eastern countries have made assumptions about the oil price in their estimates of tax receipts. Saudi Arabia has responded to lower revenues by radical cuts in public spending and privatisations – including a proposed IPO for Saudi Aramco. As The Guardian – Saudi Aramco privatisation plans shock oil sector – explains, it will certainly be difficult to value – market capitalisation estimates range from $1trln to $10trln.

Outright energy company bankruptcies are likely to be relatively subdued, unless interest rates rise dramatically – these companies locked in extremely attractive borrowing rates and their bankers will prefer to renegotiate payment schedules rather than write off the loans completely. New issuance, however, will be a rare phenomenon.


“We don’t want technology simply because it’s dazzling. We want it, create it and support it because it improves people’s lives.”

These words were uttered by Canadian Prime Minister, Justin Trudeau, at Davos last week. The commodity markets have been dealing with technology since the rise of Sumer. The Manhattan Institutes – SHALE 2.0 Technology and the Coming Big-Data Revolution in America’s Shale Oil Fields highlights some examples which go a long way to explaining the downward trajectory in oil prices over the last 18 months – emphasis is mine:-

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

…Compared with 1986—the last time the world was oversupplied with oil—there are now 2 billion more people living on earth, the world economy is $30 trillion bigger, and 30 million more barrels of oil are consumed daily. The current 33 billion-barrel annual global appetite for crude will undoubtedly rise in coming decades. Considering that fluctuations in supply of 1–2 MMbd can swing global oil prices, the infusion of 4 MMbd from U.S. shale did to petroleum prices precisely what would be expected in cyclical markets with huge underlying productive capacity.

Shipbuilding has also benefitted from technological advances in a variety of areas, not just fuel efficiency. This article (please excuse the author’s English) from Marine Insight – 7 Technologies That Can Change The Future of Shipbuilding – highlights several, I’ve chosen five:-

3-D Printing Technology:…Recently, NSWC Carderock made a fabricated model of the hospital ship USNS Comfort (T-AH 20) using its 3-D printer, first uploading CAD drawings of ship model in it. Further developments in this process can lead the industry to use this technique to build complex geometries of ship like bulbous bow easily. The prospect of using 3-D printers to seek quick replacement of ship’s part for repairing purpose is also being investigated. The Economist claims use this technology to be the “Third Industrial Revolution“.

Shipbuilding Robotics: Recent trends suggest that the shipbuilding industry is recognizing robotics as a driver of efficiency along with a method to prevent workers from doing dangerous tasks such as welding. The shortage of skilled labour is also one of the reasons to look upon robotics. Robots can carry out welding, blasting, painting, heavy lifting and other tasks in shipyards.

LNG Fueled engines

…In the LNG engines, CO2 emission is reduced by 20-25% as compared to diesel engines, NOX emissions are cut by almost 92%, while SOX and particulates emissions are almost completely eliminated.

…Besides being an environmental friendly fuel, LNG is also cheaper than diesel, which helps the ship to save significant amount of money over time.

…Solar & Wind Powered Ships:

…The world’s largest solar powered ship named ‘Turanor’ is a 100 metric ton catamaran which motored around the world without using any fuel and is currently being used as a research vessel. Though exclusive solar or wind powered ships look commercially and practically not viable today, they can’t be ruled out of future use with more technical advancements.

Recently, many technologies have come which support the big ships to reduce fuel consumption by utilizing solar panels or rigid sails. A device named Energy Sail (patent pending) has been developed by Eco Marine Power will help the ships to extract power from wind and sun so as to reduce fuel costs and emission of greenhouse gases. It is exclusively designed for shipping and can be fitted to wide variety of vessels from oil carrier to patrol ships.

Buckypaper: Buckypaper is a thin sheet made up of carbon nanotubes (CNT). Each CNT is 50,000 thinner than human air. Comparing with the conventional shipbuilding material (i.e. steel), buckypaper is 1/10th the weight of steel but potentially 500 times stronger in strength  and 2 times harder than diamond when its sheets are compiled to form a composite. The vessel built from this lighter material would require less fuel, hence increasing energy efficiency. It is corrosion resistant and flame retardant which could prevent fire on ships. A research has already been initiated for the use of buckypaper as a construction material of a future aeroplane. So, a similar trend can’t be ruled out in case of shipbuilding.

Shipping has always been a cyclical business, driven by global demand for freight on the one hand and improvements in technology on the other. The cost of production continues to fall, old inventory rapidly becomes uncompetitive and obsolete. The other factor effecting the cycle is the cost of finance; this is true also of energy exploration and development. Which brings us to the actions of the CBs.

The central role of the central banks

Had $100 per barrel oil encouraged a rise in consumer price inflation in the major economies, it might have been appropriate for their CBs to raise interest rates, however, high levels of debt kept inflation subdued. The “unintended consequences” or, perhaps we should say “collateral damage” of allowing interest rates to remain unrealistically low, is overinvestment. The BIS – Self-oriented monetary policy, global financial markets and excess volatility of international capital flows – looks at the effect developed country CB policy – specifically the Federal Reserve – has had on emerging markets:-

A major policy question arising from these events is whether US monetary policy imparts a global ‘externality’ through spillover effects on world capital flows, credit growth and asset prices. Many policy makers in emerging markets (e.g. Rajan, 2014) have argued that the US Federal Reserve should adjust its monetary policy decisions to take account of the excess sensitivity of international capital flows to US policy. This criticism questions the view that a ‘self-oriented’ monetary policy based on inflation targeting principles represents an efficient mechanism for the world monetary system (e.g. Obstfeld and Rogoff, 2002), without the need for any cross-country coordination of policies.

…Our results indicate that the simple prescriptions about the benefits of flexible exchange rates and inflation targeting are very unlikely to hold in a global financial environment dominated by the currency and policy of a large financial centre, such as the current situation with the US dollar and US monetary policy. Our preliminary analysis does suggest however that an optimal monetary policy can substantially improve the workings of the international system, even in the absence of direct intervention in capital markets through macro-prudential policies or capital controls. Moreover, under the specific assumptions maintained in this paper, this outcome can still be consistent with national independence in policy, or in other words, a system of ‘self-oriented’ monetary policy making.

Whether CBs should consider the international implications of their actions is not a new subject, but this Cobden Centre article by Alisdair Macleod – Why the Fed Will Never Succeed – suggests that the Fed should be mandated to accept a broader role:-

That the Fed thinks it is only responsible to the American people for its actions when they affect all nations is an abrogation of its duty as issuer of the reserve currency to the rest of the world, and it is therefore not surprising that the new kids on the block, such as China, Russia and their Asian friends, are laying plans to gain independence from the dollar-dominated system. The absence of comment from other central banks in the advanced nations on this important subject should also worry us, because they appear to be acting as mute supporters for the Fed’s group-think.

This is the context in which we need to clarify the effects of the Fed’s monetary policy. The fundamental question is actually far broader than whether or not the Fed should be raising rates: rather, should the Fed be managing interest rates at all? Before we can answer this question, we have to understand the relationship between credit and the business cycle.

There are two types of economic activity, one that correctly anticipates consumer demand and is successful, and one that fails to do so. In free markets the failures are closed down quickly, and the scarce economic resources tied up in them are redeployed towards more successful activities. A sound-money economy quickly eliminates business errors, so this self-cleansing action ensures there is no build-up of malinvestments and the associated debt that goes with it.

When there is stimulus from monetary inflation, it is inevitable that the strict discipline of genuine profitability that should guide all commercial enterprises takes a back seat. Easy money and interest rates lowered to stimulate demand distort perceptions of risk, over-values financial assets, and encourages businesses to take on projects that are not genuinely profitable. Furthermore, the owners of failing businesses find it possible to run up more debts, rather than face commercial reality. The result is a growing accumulation of malinvestments whose liquidation is deferred into the future.

Macleod goes on to discuss the Cantillon effect, at what point we are in the Credit Cycle and why the Fed decided to raise rates now:-

We must put ourselves in the Fed’s shoes to try to understand why it has raised rates. It has seen the official unemployment rate decline for a prolonged period, and more recently energy and commodity prices have fallen sharply. Assuming it believes government unemployment figures, as well as the GDP and its deflator, the Fed is likely to think the economy has at least stabilised and is fundamentally healthy. That being the case, it will take the view the business cycle has turned. Note, business cycle, not credit-driven business cycle: the Fed doesn’t accept monetary policy is responsible for cyclical phenomena. Therefore, demand for energy and commodities is expected to increase on a one or two-year view, so inflation can be expected to pick up towards the 2% target, particularly when the falls in commodity and energy prices drop out of the back-end of the inflation numbers. Note again, inflation is thought to be a demand-for-goods phenomenon, not a monetary phenomenon, though according to the Fed, monetary policy can be used to stimulate or control it.

Unfortunately, the evidence from multiple surveys is that after nine years since the Lehman crisis the state of the economy remains suppressed while debt has continued to increase, so this cycle is not in the normal pattern. It is clear from the evidence that the American economy, in common with the European and Japanese, is overburdened by the accumulation of malinvestments and associated debt. Furthermore, nine years of wealth attrition through monetary inflation (as described above) has reduced the purchasing power of the average consumer’s earnings significantly in real terms. So instead of a phase of sustainable growth, it is likely America has arrived at a point where the economy can no longer bear the depredations of further “monetary stimulus”. It is also increasingly clear that a relatively small rise in the general interest rate level will bring on the next crisis.

So what will the Fed – and, for that matter, other major CBs – do? I look back to the crisis of 2008/2009 – one of the unique aspects of this period was the coordinated action of the big five: the Fed, ECB, BoJ, BoE and SNB. In 1987 the Fed was the “saviour of the universe”. Their actions became so transparent in the years that followed, that the phase “Greenspan Put” was coined to describe the way the Fed saved stock market investors and corporate creditors. CEPR – Deleveraging? What deleveraging? which I have quoted from in previous letters, is an excellent introduction to the unintended consequences of CB largesse.

Since 2009 economic growth has remained sluggish; this has occurred despite historically low interest rates – it’s not unreasonable to surmise that the massive overhang of debt, globally, is weighing on both demand pull inflation and economic growth. Stock buy-backs have been rife and the long inverted relationship between dividend yields and government bond yields has reversed. Paying higher dividends may be consistent with diversifying a company’s investor base but buying back stock suggests a lack of imagination by the “C” Suite. Or perhaps these executives are uncomfortable investing when interest rates are artificially low.

I believe the vast majority of the rise in stock markets since 2009 has been the result of CB policy, therefore the Fed rate increase is highly significant. The actions of the other CBs – and here I would include the PBoC alongside the big five – is also of significant importance. Whilst the Fed has tightened the ECB and the PBoC continue to ease. The Fed appears determined to raise rates again, but the other CBs are likely to neutralise the overall effect. Currency markets will take the majority of the strain, as they have been for the last couple of years.

A collapse in equity markets will puncture confidence and this will undermine growth prospects globally. Whilst some of the malinvestments of the last seven years will be unwound, I expect CBs to provide further support. The BoJ is currently the only CB with an overt policy of “qualitative easing” – by which I mean the purchasing of common stock – I fully expect the other CBs to follow to adopt a similar approach. For some radical ideas on this subject this paper by Professor Roger Farmer – Qualitative Easing: How it Works and Why it Matters – which was presented at the St Louis Federal Reserve conference in 2012 – makes interesting reading.

Investment opportunities

In comparison to Europe– especially Germany – the US economy is relatively immune to the weakness of China. This is already being reflected in both the currency and stocks markets. The trend is likely to continue. In the emerging market arena Brazil still looks sickly and the plummeting price of oil isn’t helping, meanwhile India should be a beneficiary of cheaper oil. Some High yield non-energy bonds are likely to be “tarred” (pardon the pun) with the energy brush. Meanwhile, from an international perspective the US$ remains robust even as the US$ Index approaches resistance at 100.


Source: Marketwatch

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


Macro Letter – No 41 – 11-09-2015

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

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

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

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

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


Source: Ycharts and Investing.com

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

FRED Baa Corporate bond yield 2013-2015

Source: St Louis Federal Reserve

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

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

FRED Breakeven Inflation rate 2007-2015

Source: St Louis Federal Reserve

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

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

This is hardly hiking rhetoric.

The International perspective

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

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

Source: US Census Bureau

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

FRED USD TWI 2008-2015

Source: St Louis Federal Reserve

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

CAD and MXN vs USD 2yr

Source: Yahoo Finance

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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


Source: Fathom Consulting/Thomson Reuters

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

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

*Mexico 3yr Bonds

Source: Investing.com

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

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

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

Conclusions and investment opportunities

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

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


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


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


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