The Pension Fund Apocalypse
This is the first of two articles about negative real interest rates.
This is the first of two articles about negative real interest rates.
Macro Letter – No 120 – 13-09-2019
Uncertainty and the countdown to the US presidential elections
These are just a few of the news stories which drove financial markets during the summer: –
For financial markets it is a time of heightened uncertainty. The first two articles are provide a commentary on the way markets are evolving. The impact of social media is rising, with Trump in the vanguard. Geopolitical uncertainty and the prospect of fiscal debasement are, meanwhile, upsetting the normally inverse relationship between the price of gold and the US$.
The next two items are more market specific. The stand-off between the Chinese administration and the people of the semi-autonomous enclave of Hong Kong, prompts concern about the political stability of China, meanwhile the US Commander in Chief persists in undermining the credibility of the notionally independent Federal Reserve and seems unable to resist antagonising the Chinese administration as he raises the stakes in the Sino-US trade war. Financial markets have been understandably unsettled.
Ironically, despite the developments high-lighted above, during August, US bonds witnessed sharp reversals lower, suggesting that geopolitical tensions might have moderated. Since the beginning of September prices have rebounded, perhaps there were simply more sellers than buyers last month. In Europe, by contrast, German bunds reached new all-time highs, only to suffer sharp reversal in the past week. Equity markets responded to the political uncertainty in a more consistent manner, plunging and then recovering during the past month. As the chart below illustrates, there has been increasing debate about the challenge of increased volatility since the end of July: –
Yet, as always, it is not the volatility or even risk which presents a challenge to financial market operators, it is uncertainty. Volatility is a measure derived from the mean and variance of a price. It is a cornerstone of the measurement of financial risk: the key point is that it is measurable. Risk is something we can measure, uncertainty is that which we cannot. This is not a new observation, it was first made in 1921 by Frank Knight – Risk, Uncertainty and Profit.
Returning to the current state of the financial markets, we are witnessing a gradual erosion of belief in the omnipotence of central banks. See Macro Letter’s 48, 79 and 94 for some of my previous views. What has changed? As Keynes might have put it, ‘The facts.’ Central Banks, most notably the Bank of Japan, Swiss National Bank and European Central Bank, have been using zero or negative interest rate policy, in conjunction with balance sheet expansion, in a valiant attempt to stimulate aggregate demand. The experiment has been moderately successful, but the economy, rather like a chronic drug addict, requires an ever increasing fix to reach the same high.
In Macro Letter – No 114 – 10-05-2019 – Debasing the Baseless – Modern Monetary Theory – I discussed the latest scientific justification for debasement. My conclusion: –
The radical ideas contained in MMT are unlikely to be adopted in full, but the idea that fiscal expansion is non-inflationary provides succour to profligate politicians of all stripes. Come the next hint of recession, central banks will embark on even more pronounced quantitative and qualitative easing, safe in the knowledge that, should they fail to reignite their economies, government mandated fiscal expansion will come to their aid. Long-term bond yields will head towards the zero-bound – some are there already. Debt to GDP ratios will no longer trouble finance ministers. If stocks decline, central banks will acquire them: and, in the process, the means of production. This will be justified as the provision of permanent capital. Bonds will rise, stocks will rise, real estate will rise. There will be no inflation, except in the price of assets.
As this recent article from the Federal Reserve Bank of San Francisco – Negative Interest Rates and Inflation Expectations in Japan – indicates, even central bankers are beginning to doubt the efficacy of zero or negative interest rates, albeit, these comments emanate from the FRBSF research department rather than the president’s office. If the official narrative, about the efficacy of zero/negative interest rate policy, is beginning to change, state sponsored fiscal stimulus will have to increase dramatically to fill the vacuum. The methadone of zero rates and almost infinite credit will be difficult to quickly replace, I anticipate widespread financial market dislocation on the road to fiscal nirvana.
In the short run, we are entering a period of transition. Trump may continue to berate the chairman of the Federal Reserve and China, but his room for manoeuvre is limited. He needs Mr Market on his side to win the next election. For Europe and Japan the options are even more constrained. Come the next crisis, I anticipate widespread central bank buying of stocks (in addition to government and corporate bonds) in order to provide liquidity and insure economic stability. The rest of the task will fall to the governments. Non-inflationary fiscal profligacy will be de rigueur – I can see the politicians smiling all the way to the hustings, safe in the knowledge that deflationary forces have awarded them a free-lunch. Someone, someday, will have to pay, of course, but they will be long since retired from public office.
Conclusions and Investment Opportunities
During the next year, markets will continue to gyrate erratically, driven by the politics of European budgets, Brexit and the Sino-US trade war. These issues will be eclipsed by the twittering of Donald Trump as he seeks to win a second term in office. Looked at cynically, one might argue that Trump’s foreign policy has been deliberately engineered to slow the US economy and hold back the stock market. During the next 14 months, a new nuclear weapons agreement could be forged with Iran, relations with North Korea improved and a trade deal negotiated with China. Whether this geopolitical largesse is truly in the President’s gift remains unclear, but for a maker of deals such as Mr Trump, the prospect must be tantalising.
For the US$, the countdown to the US election remains positive, for stocks, likewise. For the bond market, the next year may be broadly neutral, but given the signs of faltering growth across the globe, it seems unlikely that yields will rise significantly. Economies will see growth slow, leading to an accelerated pace of debt issuance. Bouts of volatility, similar to August or Q4 2018, will become more commonplace. I remain bullish for asset markets, nonetheless.
As you may have seen elsewhere I have recently been invited to contribute to AIER. This article was first published in June.
AIER also operate the Bastiat Society, a global network of business professionals committed to advancing free trade, individual freedom, and responsible governance. To find a chapter near you please click on the link below: –
Macro Letter – No 118 – 12-06-2019
Low yield, no yield, negative yield – Buy now but don’t forget to sell
To many onlookers, since the great financial crisis, the world of fixed income securities has become an alien landscape. Yields on government bonds have fallen steadily across all developed markets. As the chart below reveals, there is now a record US$13trln+ of negative yielding fixed income paper, most of it issued by the governments’ of Switzerland, Japan and the Eurozone: –
The percentage of Eurozone government bonds with negative yields is now well above 50% (Eur4.3trln) and more than 35% trades with yields which are more negative than the ECB deposit rate (-0,40%). If one adds in investment grade corporates the total amount of negative yielding bonds rises to Eur5.3trln. Earlier this month, German 10yr Bund yields dipped below the deposit rate for the first time, amid expectations that the ECB will cut rates by another 10 basis points, perhaps as early as September.
The idea that one should make a long-term investment in an asset which will, cumulatively, return less at the end of the investment period, seems nonsensical, except in a deflationary environment. With most central banks committed to an inflation target of around 2%, the Chinese proverb, ‘we live in interesting times,’ springs to mind, yet, negative yielding government bonds are now ‘normal times’ whilst, to the normal fixed income investor, they are anything but interesting. As Keynes famously observed, ‘Markets can remain irrational longer than I can remain solvent.’ Do not fight this trend, yields will probably turn more negative, especially if the ECB cuts rates and a global recession arrives regardless.
Today, government and investment grade corporate debt has been joined by a baker’s dozen of short-dated high yield Euro names. This article from IFR – ‘High-yield’ bonds turn negative – explains: –
About 2% of the euro high-yield universe is now negative yielding, according to Bank of America Merrill Lynch.
That percentage would rise to 10% if average yields fall by a further 35bp, said Barnaby Martin, European credit strategist at the bank.
He said the first signs of negative yielding high-yield bonds emerged about two weeks ago in the wake of Mario Draghi’s speech in Sintra where the ECB president hinted at a further dose of bond buying via the central bank’s corporate sector purchase programme. There are now more than 10 high-yield bonds in negative territory…
The move to negative yields for European high-yield credits is unprecedented; it didn’t even happen in 2016 when the ECB began its bond buying programme.
During Q4, 2018, credit spreads widened (and stock markets declined) amid expectations of further Federal Reserve tightening and an end to ECB QE. Now, stoked by fears of a global recession, rate expectation have reversed. The Fed are likely to ease, perhaps as early as this month. The ECB, under their new broom, Christine Lagarde, is expected to embrace further QE. The corporate sector purchase program (CSPP) which commenced in June 2016, already holds Eur177.8bln of corporate bonds, but increased corporate purchases seem likely; it is estimated that the ECB holds between 25% and 30% of the outstanding Eurozone government bond in issue, near to its self-imposed ceiling of 33%. Whilst the amount in issues is less, the central bank has more flexibility with Supranational and Euro denominated non-EZ Sovereigns (50%) and greater still with corporates (70%). In this benign interest rate environment, a continued compression of credit spreads is to be expected.
Yield compression has been evident in Eurozone government bonds for decades, but now a change in relationship is starting become evident. Even if the ECB does not increase the range of corporate bonds it purchases, its influence, like the rising tide, will float all ships. Bund yields are likely to remain most negative and the government obligations of Greece, the least, but, somewhere between these two poles, corporate bonds will begin to assume the mantle of the ‘nearly risk-free.’ With many Euro denominated high-yield issues trading below the yield offered for comparable maturity Italian BTPs, certain high-yield corporate credit is a de facto alternative to poorer quality government paper.
The chart below is a snap-shot of the 3m to 3yr Eurozone yield curve. The solid blue line shows the yield of AAA rated bonds, the dotted line, an average of all bonds: –
It is interesting to note that the yield on AAA bonds, with a maturity of less than two years, steadily becomes less negative, whilst the aggregated yield of all bonds continues to decline.
The broader high-yield market still offers positive yield but the Eurozone is likely to be the domicile of choice for new issuers, since Euro high-yield now trades at increasingly lower yields than the more liquid US market, the liquidity tail is wagging the dog: –
Source: Bloomberg, Barclays
The yield compression within the Eurozone has been more dramatic but it has been mirrored by the US where the spread between BBB and BB narrowed to a 12 year low of 60 basis points this month.
Wither away the dealers?
Forgotten, amid the inexorable bond rally, is dealer liquidity, yet it is essential, especially when investors rush for the exit simultaneously. For corporate bond market-makers and brokers the impact of QE has been painful. If the ECB is a buyer of a bond (and they pre-announce their intentions) then the market is guaranteed to rise. Liquidity is stifled in a game of devil take the hindmost. Alas, non-eligible issues, which the ECB does not deign to buy, find few natural buyers, so few institutions can justify purchases when credit default risk remains under-priced and in many cases the yield to maturity is negative.
An additional deterrent is the cost of holding an inventory of fixed income securities. Capital requirements for other than AAA government paper have increased since 2009. More damaging still is the negative carry across a wide range of instruments. In this environment, liquidity is bound to be impaired. The danger is that the underlying integrity of fixed income markets has been permanently impaired, without effective price intermediation there is limited price discovery: and without price discovery there is a real danger that there will be no firm, ‘dealable’ prices when they are needed most.
In this article from Bloomberg – A Lehman Survivor Is Prepping for the Next Credit Downturn – the interviewee, Pilar Gomez-Bravo of MFS Investment Management, discusses the problem of default risk in terms of terms of opacity (the emphasis is mine): –
Over a third of private high-yield companies in Europe, for example, restrict access to financial data in some way, according to Bloomberg analysis earlier this year. Buyers should receive extra compensation for firms that curb access to earnings with password-protected sites, according to Gomez-Bravo.
Borrowers still have the upper hand in the U.S. and Europe. Thank cheap-money policies and low defaults. Speculation the European Central Bank is preparing for another round of quantitative easing is spurring the rally — and masking fragile balance sheets.
Borrowers still have the upper hand indeed, earlier this month Italy issued a Eur3bln tranche of its 2.8% coupon 50yr BTP; there were Eur17bln of bids from around 200 institutions (bid/cover 5.66, yield 2.877%). German institutions bought 35% of the issue, UK investors 22%. The high bid/cover ratio is not that surprising, only 1% of Euro denominated investment grade paper yields more than 2%.
I am not alone in worrying about the integrity of the bond markets in the event of another crisis, last September ESMA – Liquidity in EU fixed income markets – Risk indicators and EU evidence concluded: –
Episodes of short-term volatility and liquidity stress across several markets over the past few years have increased concerns about the worsening of secondary market liquidity, in particular in the fixed income segment…
…our findings show that market liquidity has been relatively ample in the sovereign segment, potentially also due to the effects of supportive economic policies over more recent years. This is different from our findings in the corporate bond market, where in recent years we did not find systematic and significant drop in market liquidity but we observed episodes of decreasing market liquidity when market conditions deteriorated…
We find that in the sovereign bond segment, bonds that have a benchmark status and are characterised by larger outstanding amounts tend to be more liquid while market volatility is negatively related to market liquidity. Outstanding amounts are the main bond-level drivers in the corporate bond segment…
With reference to corporate bond markets, the sensitivity of bond liquidity to bond-specific and market factors is larger when financial markets are under stress. In particular, bonds characterised by more volatile market liquidity are found to be more vulnerable in periods of market stress. This empirical result is consistent with the market liquidity indicators developed for corporate bonds pointing at episodes of decreasing market liquidity when wider market conditions deteriorate.
ESMA steer clear of discussing negative yields and their impact on the profitability of market-making, but the BIS annual economic report, published last month, has no such qualms (the emphasis is mine): –
Household debt has reached new historical peaks in a number of economies that were not at the heart of the GFC, and house price growth has in many cases stalled. For a group of advanced small open economies, average household debt amounted to 101% of GDP in late 2018, over 20 percentage points above the pre-crisis level… Moreover, household debt service ratios, capturing households’ principal and interest payments in relation to income, remained above historical averages despite very low interest rates…
…corporate leverage remained close to historical highs in many regions. In the United States in particular, the ratio of debt to earnings in listed firms was above the previous peak in the early 2000s. Leverage in emerging Asia was still higher, albeit below the level immediately preceding the 1990s crisis. Lending to leveraged firms – i.e. those borrowing in either high-yield bond or leveraged loan markets – has become sizeable. In 2018, leveraged loan issuance amounted to more than half of global publicly disclosed loan issuance loans excluding credit lines.
… following a long-term decline in credit quality since 2000, the share of issuers with the lowest investment grade rating (including financial firms) has risen from around 14% to 45% in Europe and from 29% to 36% in the United States. Given widespread investment grade mandates, a further drop in ratings during an economic slowdown could lead investors to shed large amounts of bonds quickly. As mutual funds and other institutional investors have increased their holdings of lower-rated debt, mark-to-market losses could result in fire sales and reduce credit availability. The share of bonds with the lowest investment grade rating in investment grade corporate bond mutual fund portfolios has risen, from 22% in Europe and 25% in the United States in 2010 to around 45% in each region.
How financial conditions might respond depends also on how exposed banks are to collateralised loan obligations (CLOs). Banks originate more than half of leveraged loans and hold a significant share of the least risky tranches of CLOs. Of these holdings, US, Japanese and European banks account for around 60%, 30% and 10%, respectively…
…the concentration of exposures in a small number of banks may result in pockets of vulnerability. CLO-related losses could reveal that the search-for-yield environment has led to an underpricing and mismanagement of risks…
In the euro area, the deterioration of the growth outlook was more evident, and so was its adverse impact on an already fragile banking sector. Price-to-book ratios fell further from already depressed levels, reflecting increasing concerns about banks’ health…
Unfortunately, bank profitability has been lacklustre. In fact, as measured, for instance, by return-on-assets, average profitability across banks in a number of advanced economies is substantially lower than in the early 2000s. Within this group, US banks have performed considerably better than those in the euro area, the United Kingdom and Japan…
…persistently low interest rates and low growth reduce profits. Compressed term premia depress banks’ interest rate margins from maturity transformation. Low growth curtails new loans and increases the share of non-performing ones. Therefore, should growth decline and interest rates continue to remain low following the pause in monetary policy normalisation, banks’ profitability could come under further pressure.
Conclusion and investment opportunities
Back in 2006, when commodity investing, as part of a diversified portfolio, was taking the pension fund market by storm, I gave a series of speeches in which I beseeched fund managers to consider carefully before investing in commodities, an asset class which had for more than 150 years exhibited a negative expected real return.
An astonishingly large percentage of fixed income securities are exhibiting similar properties today. My advice, then for commodities and today, for fixed income securities, is this, ‘By all means buy, but remember, this is a trading asset, its long-term expected return is negative; in other words, please, don’t forget to sell.’
Macro Letter – No 115 – 24-05-2019
Trade Wars, the prospects for freer trade and the impact on asset prices
As Sino-US trade talks ended, not only, without a deal, but with another sharp increase in tariffs, it is worth looking at what has happened and why. During 2018 the US reversed 38 years of tariff reduction with a radical abruptness, imposing tariffs on 50% of Chinese imports, China retaliated in kind, imposing tariffs on 70% of US imports. The Peterson Institute – The 2018 US-China Trade Conflict after 40 Years of Special Protection – published before the recent tariff increases, reviews the situation in detail. The author, Chad Brown, begins by looking at the tariff reductions since the late 1980’s. For the US, these tariffs had fallen from 5% to 3%, whilst for China they declined from 40% to 8% by 2017. Over the same period China’s share of US imports rose from near to zero in 1978 to 20% by 2014. By contrast, Chinese imports from the US rose steadily, reaching 10% in 2001 – which coincided with their ascension to the World Trade Organisation (WTO) – however, since then, imports from the US have declined, dipping to 8.5% by 2017. In bilateral terms Chinese imports from the US are about a quarter of her exports to the land of the free.
At first sight, it might seem as if the trade tensions between China and the US are new, but relations have been deteriorating since the bursting of the US Tech bubble in 2001, if not before. Looking at the chart below, which measures antidumping and countervailing tariffs, it appears as if the Chinese did not begin to retaliate until 2006: –
Source: Peterson Institute
Analysing anti-dumping and countervailing tariffs in isolation, however, gives a misleading impression of the US response to China. Peterson research attempts to assess the entire scope of the Sino-US trade dispute, by incorporating all forms of US special protection against China over the entire period. The next chart shows the true scale of US tariff reduction on Chinese imports; seen in this light, the extent of the recent policy shift is even more dramatic: –
Source: Peterson Institute
Using this combined metric, US special protection peaked at 39% in 1986, after which these barriers declined rapidly reaching a nadir at 4.3% in 2005. On the eve of the trade war in 2017 barriers had risen to 8.1%. Prior to the May 10th tariff increase, that figure had jumped to 50%. An updated version of the Peterson chart of shown below: –
Source: Peterson Institute
The additional tariffs imposed this month will raise the average US tariff on Chinese goods to 18.3%. If Trump follows through with his threat to impose a 25% tariff on most of the rest of US imports from China, the average US tariff toward China would increase to 27.8%.
Source: Peterson Institute
What is the likely impact of these actions on trade and prices? For the US, import prices will increase, but given that US inflation has tended to be below the Fed target, this is manageable; corporates and consumers will pay the cost of tariffs, the tax receipts will help to finance the cost of recent US tax cuts. In China, whilst the impact is still negative, as this recent article from CFR – China Never Stopped Managing its Trade makes clear, the majority of imports are made by state owned enterprises or by companies which have a government permit to import such goods, added to which Chinese inflation has also been reasonably subdued, despite impressive continued economic expansion: –
When the state controls the firms that are doing the importing, a few phone calls can have a big impact. That’s why China can shut down trade in canola with Canada without formally introducing any tariffs.
That’s why China can scale back its purchases of Australian coal without filing a “dumping” or “national security” tariffs case.
And that’s why—when the trade war with the United States started—U.S. exports in a number of goods simply went to zero (normally, a 25 percent tariff would reduce imports by more like 50 percent or something…]
For US companies the four largest exports to China are aircraft, automobiles, soybeans and oil and gas. Of these, only automobiles are sold directly to the private sector. Here are three charts which explain why, for the US (at least in the near-term) there may be less to lose in this global game of chicken: –
Source: US Census Bureau, Haver Analytics
Source: US Census Bureau, Haver Analytics
Source: US Census Bureau, Haver Analytics
The decline in US imports has been driven by a combination of substitution for imports from other sources and a rising domestic capability to manufacture intermediate goods. Faced with a dwindling market for their exports, the US might be forgiven for wishing to retire from the fray whilst it still has the advantage of being the ‘consumer of last resort’.
To date, US government receipts from tariff increases have amounted to an estimated $2bln. A study by the World Bank and the International Finance Corporation, however, estimates the true cost the US economy has been nearer to $6.4bln or 0.03% of GDP. The chart below shows the already substantial divergence between prices for tariff versus non-tariff goods: –
Source: Financial Sense, US Department of Labor, Commerce department, Goldman Sachs
The impact on China is more difficult to measure since Chinese statistics are difficult interpret, however, only 18% of Chinese exports are to the US – that equates to $446bln out of a total of $2.48trln in 2018, added to which, exports represent only 20% of Chinese GDP – all US imports amount to 3.6% of Chinese GDP.
The scale of the dispute (bilateral rather than multilateral) should not detract from its international significance. One institution which seen its credibility undermined by the imposition of US tariffs is the World Trade Organisation (WTO) – Chatham House – The Path Forward on WTO Reform provides an excellent primer to this knotty issue. Another concern, for economists, is that history is repeating itself. They fear Trump’s policies are a redux of the infamous Smoot-Hawley tariffs, imposed during the great depression. Peterson – Does Trump Want a Trade War? from March 2018 and Trump’s 2019 Protection Could Push China Back to Smoot-Hawley Tariff Levels published this month are instructive on this topic. These tariffs were implemented on 17th June 1930 and applied to hundreds of products. To put today’s dispute in perspective, the 1930’s tariff increase was only from 38% to 45% – a mere 18% increase – this month tariffs have increased from 10% to 25%: a 150% increase. Those who note that 25% is still well below 1930’s levels should not be complaisant, China remains a WTO member, were it not, US average tariffs would now be 38%. Back in 2016 President Trump talked of raising tariffs on Chinese imports to 45%, a number cunningly lifted from the Smoot-Hawley playbook.
One of the counter-intuitive effects of the 1930’s tariff increase was price deflation, in part due to many tariffs being imposed on a per unit cost basis. Today, per unit tariffs apply to only around 8% of goods, added to which, due to monetary engineering, by central banks, and the issuance of fiat currency by governments, the threat of real deflation is less likely.
Another risk is that the Sino-US spat engulfs other countries. The EU (especially Germany) has already suffered the ire of the US President. Recent trade deals between the EU and both Canada and Japan, have been heralded as a triumph for free-trade, however, they are an echo of the trading blocs which formed during the 1930’s. To judge by Trump’s recent tweets, for the moment, China has been singled out, on 13th May the President said: –
“Also, the Tariffs can be completely avoided if you buy from a non-Tariffed Country, or you buy the product inside the USA (the best idea). That’s Zero Tariffs. Many Tariffed companies will be leaving China for Vietnam and other such countries in Asia. That’s why China wants to make a deal so badly!”
Even if the trade dispute remains a Sino-US affair, there are other unseen costs to consider, on productivity and investment, Bruegal – Implications of the escalating China-US trade dispute takes up the discussion (emphasis mine): –
The direct aggregate effect of the tariffs on the welfare of the US and Chinese, while negative, is likely to be very small… because they represent a transfer from consumers, importers and partner exporters to the government… sooner or later, the American consumer will bear much of the cost of the tariff though higher prices, but also that tariff revenue will return to American residents in some form. The negative aggregate welfare effect of tariffs thus arises because, at the margin, they displace more efficient producers by less efficient ones… because, at the margin, tariffs artificially reduce the consumption or use of imports in favour of domestic goods or goods imported from third parties…
The distributional effect of tariffs is likely to be very uneven and severely negative on some people and sectors… while the Treasury will see increased revenue, and some producers who compete with imports will gain, small companies that depend on imported parts from China are likely to be very badly affected by tariffs…
Larger importers will also be adversely affected… US farmers who depend on Chinese markets have already been badly hurt by Chinese retaliation…
The biggest adverse effects of tariffs on aggregate economic activity is through investment. Lower investment is the natural result of the tariffs’ big distributional effects… and the uncertainty they engender. This effect on ‘animal spirits’ is difficult to model and impossible to quantify with precision… The extraordinary sensitivity of stock markets to trade news and their volatility is just one manifestation of this effect. The widening growth gap between the global manufacturing and services sectors evident in recent quarters is another, as is the slowdown in investment in many countries.
Bruegal go on to discuss the risk to the international trading system and the damage to the credibility of the WTO. Finally they suggest that the trade dispute is a kind of proxy-war between the two super-powers: this is much more than just a trade dispute.
Putting the Sino-US dispute in an historical context, a number of commentators have drawn comparisons between China today and Japan in the 1980’s. I believe the situation is quite different, as will be the outcome. Again, I defer to Bruegal – Will China’s trade war with the US end like that of Japan in the 1980s? The author’s argue that Japan chose to challenge the US when it was close to its economic peak and its productivity was stagnating. China, by contrast, has a younger population, rapidly improving productivity and, most importantly, remains a significant way below its economic peak: –
…Because China is at an earlier stage of economic development, it is expected to challenge the US hegemony for an extended period of time. Therefore, the US-China trade war could last longer than the one with Japan. With China’s growth prospects still relatively solid – it will soon overtake the US economy in size and it does not depend on the US militarily – China will likely challenge US pressure in the ongoing negotiations for a settlement to the trade war. This also means that any deal will only be temporary, as the US will not be able to contain China as easily as it contained Japan.
If you are looking for a more global explanation of the current dispute between the US and China, then this article from CFR – The Global Trading System: What Went Wrong and How to Fix It is instructive: –
As economist Richard Baldwin lays out in his book The Great Convergence, the Industrial Revolution of the 19th century had launched Europe, the US, Japan and Canada on a trajectory that would see their wealth surge ahead of the rest of the world. In 1820, for example, incomes in the US were about three times those of China; by 1914 Americans would be 10 times as wealthy as Chinese. Manufacturing clustered in the technologically advanced countries, while advances in containerized shipping and the lowering of tariffs through trade negotiations made it possible for these countries to specialize and trade in the classic Ricardian fashion.
The information technology revolution of the 1990s turned that story upside down. With the advent of cheap, virtually instant global communications via the Internet, it became possible – and then imperative for competitive success – for multinational companies to take their best technologies and relocate production in lower-wage countries. Manufacturing output rose in middle-income countries like China, India, Thailand, Poland and others, while falling sharply in the US, Japan, France, the UK and even Germany…
The global great convergence, however, coincided with a great divergence within the wealthy countries (and many developing countries as well). The new technologies and the disappearance of trade barriers upended the balance between labor and capital in the advanced industrialized countries, and contributed to soaring economic inequality…
In the US in 1979, an American with a college degree or higher earned about 50% more than one who had only a high school education or less. By 2018, American workers with a four-year college degree earned almost twice as much as those with just a high-school education, and were unemployed half as often, while those with a professional degree earned nearly three times as much.
The author goes on to liken today’s tension between the US and China with the situation which existed between the UK and US at the beginning of the 20th century: –
The world today again faces the same governance gap – a US that no longer has the economic muscle nor the political will to organize the global system, and a rising China that is reluctant to play a greater role.
CFR ask what the prospects maybe for renewed globalization? They identify three key elements which need to be addressed in order for de-globalisation to be reversed: a trade war truce (once both sides wake up to the extent of the empasse they have engineered), a filling the Leadership Vacuum (caused by both sides turning their backs on the WTO – they need to reengage and lead the world towards a solution) and, especially for the US, meeting the challenges at home (Trump cannot rely on a trade war in the long-run to solve the problem of inequality within the US).
Conclusions and investment opportunities
What is the likely impact on financial markets? To answer this question one needs to know whether the current trade war will escalate or dissipate: and if it escalates, will it be short and sharp or protracted and pernicious?
Alisdair Macleod of Gold Money – Post-tariff considerations identifies the following factors: –
The effect of the new tariff increases on trade volumes
The effect on US consumer prices
The effect on US production costs of tariffs on imported Chinese components
The consequences of retaliatory action on US exports to China
The recessionary impact of all the above on GDP
The consequences for the US budget deficit, allowing for likely tariff income to the US Treasury
Leading, in MacLeod’s opinion, to: –
Reassessment of business plans in the light of market information
A tendency for bank credit to contract as banks anticipate heightened lending risk
Liquidation of financial assets held by banks as collateral
Foreign liquidation of USD assets and deposits
The government’s borrowing requirement increasing unexpectedly
Bond yields rising to discount increasing price inflation
Banks facing increasing difficulties and the re-emergence of systemic risk
The author suggests that, all other things equal, tariffs should lead to price increases, but, with the US consumer already heavily burdened with debt, consumption demand will suffer.
I am less bearish than MacLeod because, if the Sino-US trade war threatens to puncture the decade long equity bull-market, we will see a combination of qualitative and quantitative easing from the largest central banks and aggressive fiscal stimulus from the governments of G20 and beyond. I wrote about this scenario (though without reference to the trade war) earlier this month in Macro Letter – No 114 – 10-05-2019 – Debasing the Baseless – Modern Monetary Theory. My, perhaps overly simple, prediction for assets in the longer-term is: bonds up, stocks up and real estate up.
In an alternative scenario, we might encounter asset price deflation and consumer price inflation occurring simultaneously. Worse still, this destructive combination of forces might coinciding with a global recession. The severity of any recession – and the inevitable correction to financial markets that such an economic downturn would precipitate – will depend entirely on the time it takes for US and Chinese trade negotiators to realise the danger and reach a compromise. I believe they will do so relatively quickly.
Attempting to predict what President Trump might do next is fraught with danger, but, due to the inherent weakness of the democratic process, I expect the US administration to concede. The US President has an election to win in November 2020; the President of China has been elected for life.
Macro Letter – No 110 – 15-02-2019
Central bank balance sheet reductions – will anyone follow the Fed?
The Federal Reserve’s response to the great financial recession of 2008/2009 was swift by comparison with that of the ECB; the BoJ was reticent, too, due to its already extended balance sheet. Now that the other developed economy central banks have fallen into line, the question which dominates markets is, will other central banks have room to reverse QE?
Last month saw the publication of a working paper from the BIS – Risk endogeneity at the lender/investor-of-last-resort – in which the authors investigate the effect of ECB liquidity provision, during the Euro crisis of 2010/2012. They also speculate about the challenge balance sheet reduction poses to systemic risk. Here is an extract from the non-technical summary (the emphasis is mine): –
The Eurosystem’s actions as a large-scale lender- and investor-of-last-resort during the euro area sovereign debt crisis had a ﬁrst-order impact on the size, composition, and, ultimately, the credit riskiness of its balance sheet. At the time, its policies raised concerns about the central bank taking excessive risks. Particular concern emerged about the materialization of credit risk and its eﬀect on the central bank’s reputation, credibility, independence, and ultimately its ability to steer inﬂation towards its target of close to but below 2% over the medium term.
Against this background, we ask: Can central bank liquidity provision or asset purchases during a liquidity crisis reduce risk in net terms? This could happen if risk taking in one part of the balance sheet (e.g., more asset purchases) de-risks other balance sheet positions (e.g., the collateralized lending portfolio) by a commensurate or even larger amount. How economically important can such risk spillovers be across policy operations? Were the Eurosystem’s ﬁnancial buﬀers at all times suﬃciently high to match its portfolio tail risks? Finally, did past operations diﬀer in terms of impact per unit of risk?…
We focus on three main ﬁndings. First, we ﬁnd that (Lender of last resort) LOLR- and (Investor of last resort) IOLR-implied credit risks are usually negatively related in our sample. Taking risk in one part of the central bank’s balance sheet (e.g., the announcement of asset purchases within the Securities Market Programme – SMP) tended to de-risk other positions (e.g., collateralized lending from previous – longer-term refinancing operations LTROs). Vice versa, the allotment of two large-scale (very long-term refinancing operations) VLTRO credit operations each decreased the one-year-ahead expected shortfall of the SMP asset portfolio. This negative relationship implies that central bank risks can be nonlinear in exposures. In bad times, increasing size increases risk less than proportionally. Conversely, reducing balance sheet size may not reduce total risk by as much as one would expect by linear scaling. Arguably, the documented risk spillovers call for a measured approach towards reducing balance sheet size after a ﬁnancial crisis.
Second, some unconventional policy operations did not add risk to the Eurosystem’s balance sheet in net terms. For example, we ﬁnd that the initial OMT announcement de-risked the Eurosystem’s balance sheet by e41.4 bn in 99% expected shortfall (ES). As another example, we estimate that the allotment of the ﬁrst VLTRO increased the overall 99% ES, but only marginally so, by e0.8 bn. Total expected loss decreased, by e1.4 bn. We conclude that, in extreme situations, a central bank can de-risk its balance sheet by doing more, in line with Bagehot’s well-known assertion that occasionally “only the brave plan is the safe plan.” Such risk reductions are not guaranteed, however, and counterexamples exist when risk reductions did not occur.
Third, our risk estimates allow us to study past unconventional monetary policies in terms of their ex-post ‘risk eﬃciency’. Risk eﬃciency is the notion that a certain amount of expected policy impact should be achieved with a minimum level of additional balance sheet risk. We ﬁnd that the ECB’s Outright Monetary Transactions – OMT program was particularly risk eﬃcient ex-post since its announcement shifted long-term inﬂation expectations from deﬂationary tendencies toward the ECB’s target of close to but below two percent, decreased sovereign benchmark bond yields for stressed euro area countries, while lowering the risk inherent in the central bank’s balance sheet. The ﬁrst allotment of VLTRO funds appears to have been somewhat more risk-eﬃcient than the second allotment. The SMP, despite its beneﬁts documented elsewhere, does not appear to have been a particularly risk-eﬃcient policy measure.
This BIS research is an important assessment of the effectiveness of ECB QE. Among other things, the authors find that the ‘shock and awe’ effectiveness of the first ‘quantitative treatment’ soon diminished. Liquidity is the methadone of the market, for QE to work in future, a larger and more targeted dose of monetary alchemy will be required.
The paper provides several interesting findings, for example, the Federal Reserve ‘taper-tantrum’ of 2013 and the Swiss National Bank decision to unpeg the Swiss Franc in 2015, did not appear to influence markets inside the Eurozone, once ECB president, Mario Draghi, had made its intensions plain. Nonetheless, the BIS conclude that (emphasis, once again, is mine): –
…collateralized credit operations imply substantially less credit risks (by at least one order of magnitude in our crisis sample) than outright sovereign bond holdings per e1 bn of liquidity owing to a double recourse in the collateralized lending case. Implementing monetary policy via credit operations rather than asset holdings, whenever possible, therefore appears preferable from a risk eﬃciency perspective. Second, expanding the set of eligible assets during a liquidity crisis could help mitigate the procyclicality inherent in some central bank’s risk protection frameworks.
In other words, rather than exacerbate the widening of credit spreads by purchasing sovereign debt, it is preferable for central banks to lean against the ‘flight to quality’ tendency of market participants during times of stress.
The authors go on to look at recent literature on the stress-testing of central bank balance sheets, mainly focussing on analysis of the US Federal Reserve. Then they review ‘market-risk’ methods as a solution to the ‘credit-risk’ problem, employing non-Gaussian methods – a prescient approach after the unforeseen events of 2008.
Bagehot thou shouldst be living at this hour (with apologies to Wordsworth)
The BIS authors refer on several occasions to Bagehot. I wonder what he would make of the current state of central banking? Please indulge me in this aside.
Walter Bagehot (1826 to 1877) was appointed by Richard Cobden as the first editor of the Economist. He is also the author of perhaps the best known book on the function of the 19th century money markets, Lombard Street (published in 1873). He is famed for inventing the dictum that a central bank should ‘lend freely, at a penalty rate, against good collateral.’ In fact he never actually uttered these words, they have been implied. Even the concept of a ‘lender of last resort’, to which he refers, was not coined by him, it was first described by Henry Thornton in his 1802 treatise – An Enquiry into the Nature and Effects of the Paper Credit of Great Britain.
To understand what Bagehot was really saying in Lombard Street, this essay by Peter Conti-Brown – Misreading Walter Bagehot: What Lombard Street Really Means for Central Banking – provides an elegant insight: –
Lombard Street was not his effort to argue what the Bank of England should do during liquidity crises, as almost all people assume; it was an argument about what the Bank of England should openly acknowledge that it had already done.
Bagehot was a classical liberal, an advocate of the gold standard; I doubt he would approve of the nature of central banks today. He would, I believe, have thrown his lot in with the likes of George Selgin and other proponents of Free Banking.
Conclusion and Investment Opportunities
Given the weakness of European economies it seems unlikely that the ECB will be able to follow the lead of the Federal Reserve and raise interest rates in any meaningful way. The unwinding of, at least a portion of, QE might be easier, since many of these refinancing operations will naturally mature. For arguments both for and against CB balance sheet reduction this paper by Charles Goodhart – A Central Bank’s optimal balance sheet size? is well worth reviewing. A picture, however, is worth a thousand words, although I think the expected balance sheet reduction may be overly optimistic: –
Source: IMF, Haver Analytics, Fulcrum Asset Management
Come the next crisis, I expect the ECB to broaden the range of eligible securities and instruments that it is prepared to purchase. The ‘Draghi Put’ will gain greater credence as it encompasses a wider array of credits. The ‘Flight to Quality’ effect, driven by swathes of investors forsaking equities and corporate bonds, in favour of ‘risk-free’ government securities, will be shorter-lived and less extreme. The ‘Convergence Trade’ between the yields of European government bonds will regain pre-eminence; I can conceive the 10yr BTP/Bund spread testing zero.
None of this race to zero will happen in a straight line, but it is important not to lose sight of the combined power of qualitative and quantitative easing. The eventual ‘socialisation’ of common stock is already taking place in Japan. Make no mistake, it is already being contemplated by a central bank near you, right now.
Macro Letter – No 108 – 18-01-2019
A world of debt – where are the risks?
Since the financial crisis of 2008/2009 global debt has increased to reach a new all-time high. This trend has been documented before in articles such as the 2014 paper from the International Center for Monetary and Banking Studies – Deleveraging? What deleveraging? The IMF have also been built a global picture of the combined impact of private and public debt. In a recent publication – New Data on Global Debt – IMF – the authors make some interesting observations: –
Global debt has reached an all-time high of $184 trillion in nominal terms, the equivalent of 225 percent of GDP in 2017. On average, the world’s debt now exceeds $86,000 in per capita terms, which is more than 2½ times the average income per-capita.
The most indebted economies in the world are also the richer ones. You can explore this more in the interactive chart below. The top three borrowers in the world—the United States, China, and Japan—account for more than half of global debt, exceeding their share of global output.
The private sector’s debt has tripled since 1950. This makes it the driving force behind global debt. Another change since the global financial crisis has been the rise in private debt in emerging markets, led by China, overtaking advanced economies. At the other end of the spectrum, private debt has remained very low in low-income developing countries.
Global public debt, on the other hand, has experienced a reversal of sorts. After a steady decline up to the mid-1970s, public debt has gone up since, with advanced economies at the helm and, of late, followed by emerging and low-income developing countries.
The recent picture suggests that the old world order, dominated by advanced economies, may be changing. For investors, this is an important consideration. Total debt in 2017 had exceeded the previous all-time high by more than 11%, however, the global debt to GDP ratio fell by 1.5% between 2016 and 2017, led by developed nations.
Setting aside the absolute level of interest rates, which have finally begun to rise from multi-year lows, it makes sense for rapidly aging, developed economies, to begin reducing their absolute level of debt, unfortunately, given that unfunded pension liabilities and the escalating cost of government healthcare provision are not included in the data, the IMF are only be portraying a partial picture of the state of developed economy obligations.
For emerging markets, the trauma of the 1998 Asian Crisis has finally waned. In the decade since the great financial recession of 2008 emerging economies, led by China, have increased their borrowing. This is clearly indicated in the chart below: –
The decline in the global debt to GDP ratio in 2017 is probably related to the change in Federal Reserve policy; the largest proportion of global debt is still raised in US$. Rather like the front-loaded US growth which transpired due the threat of tariff increases on US imports, I suspect, debt issuance spiked in expectation of a reversal of quantitative easing and an end to ultra-low US interest rates.
The IMF goes on to show the breakdown of debt by country, separating them into three groups; advanced economies, emerging markets and low income countries. The outlier is China, an emerging market with a debt to GDP ratio comparable to that of an advanced economy. The table below may be difficult to read (an interactive one is available on the IMF website): –
At 81%, China’s private debt is much greater than its public debt, meanwhile its debt to GDP ratio is 254% – comparable with the US (256%). Fortunately, the majority of Chinese private debt is denominated in local currency. Advanced economies have higher debt to GDP ratios but their government debt ratios are relatively modest, excepting Japan. The Economist – Economists reconsider how much governments can borrow – provides food for thought on this subject.
Excluding China, emerging markets and low income countries have relatively similar levels of debt relative to GDP. In general, the preponderance of government debt in lower ratio countries reflects the lack of access to capital markets for private sector borrowers.
Conclusions and Investment Opportunities
Setting aside China, which, given its control on capital flows and foreign exchange reserves is hard to predict, the greatest risk to world financial markets appears to be from the private debt of advanced economies.
Following the financial crisis of 2008, corporate credit spreads narrowed, but not by as much as one might have anticipated, as interest rates tended towards the zero bound. The inexorable quest for yield appears to have been matched by equally enthusiastic issuance. The yield-quest also prompted the launch of a plethora of private debt investment products, offering enticing returns in exchange for illiquidity. An even more sinister trend has been the return of many of the products which exacerbated the financial crisis of 2008 – renamed, repackaged and repurposed. These investments lack liquidity and many are leveraged in order to achieve acceptable rates of return.
The chart below shows the 10yr maturity Corporate Baa spread versus US Treasuries since March 2007: –
Source: Federal Reserve Bank of St Louis
The Baa spread has widened since its low of 1.58% in January 2018, but, at 2.46%, it is still only halfway between the low of 2018 and the high of February 2016 (3.6%).
The High Yield Bond spread experienced a more dramatic reaction into the close of 2018, but, since the beginning of January, appears to have regained its composure. The chart shows the period since September 2015: –
Source: Federal Reserve Bank of St Louis
Nonetheless, this looks more like a technical break-out. The spread may narrow to retest the break of 4% seen on November 15th, but the move looks impulsive. A return to the 3.25% – 3.75% range will be needed to quell market fears of an imminent full-blown credit-crunch.
If the next crisis does emanate from the private debt markets, governments will still be in a position to intervene; the last decade has taught us to accept negative government bond yields as a normal circumstance. Demographic trends have even led long dated interest rate swaps to trade even lower than risk-free assets.
A decade after the financial crisis, markets are fragile and, with an ever increasing percentage of capital market transactions dictated by non-bank liquidity providers, liquidity is ever more transitory. Credit spreads have often been the leading indicator of recessions, they may not provide the whole picture this time, but we should watch them closely during 2019.
Macro Letter – No 107 – 04-01-2019
Emerging Market Sensitivity to US Monetary Policy – What does the Fed think?
In Macro Letter – No 96 – 04-05-2018 – Is the US exporting a recession? I speculated on whether US tightening of monetary policy and the reversal of QE was causing more difficulty for emerging markets – and even perhaps Europe – than it was for the domestic US economy. I was therefore delighted to receive an update on 9th December from the Federal Reserve Bank of Dallas, entitled, Reserve Adequacy Explains Emerging-Market Sensitivity to U.S. Monetary Policy. The authors, J. Scott Davis, Dan Crowley and Michael Morris, remind readers that Past-Chairman Greenspan made the following observations after the Asian crisis of 1997/98: –
In a 1999 speech to the World Bank, Greenspan summarized the rule stating “that countries should manage their external assets and liabilities in such a way that they are always able to live without new foreign borrowing for up to one year.
Personally I find the choice of one year to be a conveniently arbitrary time period, but the remark was probably more concerned with prudence, after the event, than an attempt to model the sudden-stop over time. It also ties in with the generally agreed definition of a country’s short-term debt, that which has to be repaid or rolled over within a year.
The authors go on to discuss reserve balances: –
Reserves are a safety net to guard against currency instability when major advanced economy central banks tighten policy.
The burning question is, what level of reserves is necessary to insure the stability of one’s currency? The authors suggest that this should be the following equation: –
FX reserves – Short-term foreign-currency denominated external debt + current account deficit
Their solution is to observe daily changes in the interest rate spread between the Corporate Emerging Market Bond Index (CEMBI) and 12 month Fed Fund Futures. To relate this to the level of central bank reserves an ‘interaction term’ is constructed which describes to relationship between reserve levels and credit spreads. An iterative process arrives at a level of reserves relative to a countries GDP. One may argue about the flaws in this simple model, however, it arrives at the conclusion that a 7.1% central bank currency reserve adequacy to GDP ratio is the inflection point: –
To that end, a range of possible threshold values is tested—from reserve adequacy of -10 percent of GDP to 20 percent of GDP. The threshold value most supported is 7.1 percent of GDP. When reserve adequacy is less than that, the sensitivity of the CEMBI spread to changes in fed funds futures is proportional to a country’s reserve adequacy, with the CEMBI spread becoming more sensitive as reserve adequacy declines. Reserve adequacy above 7.1 percent doesn’t much affect CEMBI sensitivity to expectations of U.S. monetary policy— sensitivity is similar whether reserve adequacy is 9 percent or 29 percent.
The chart below shows the level of reserves for selected EM countries since 2010, the colour coding shows in red those countries with reserves less than 7.1% of GDP and in blue those above the threshold: –
Sources: International Monetary Fund; Bank for International Settlements; World Bank; Haver Analytics
China has maintained extremely high reserves despite maintaining fairly tight currency controls. The table above shows PBoC reserves gently declining but they remain well above the 7.1% inflection point.
Observations and recommendations
The Fed model is elegantly simple, it would be interesting to investigate its applicability to smaller developed economies; I imagine a similar pattern may be observed, although the reserve requirement inflection point might be lower, a reflection of the depth of their domestic capital markets. I also wonder about the effect of the absolute level of interest rates and the interest rate differential between one country and its reserve currency comparator – not all emerging markets peg themselves to the US$.
This study could also be applied to frontier economies although it may not necessarily be so effective in measuring risk when the statistical basis of GDP and other statistical measurements is suspect – consider the recent upward revisions of the economic size of countries such as Nigeria and Ghana. This paper from World Economics – Measuring GDP in Africa – March 2016 – has more detail.
As part of an initial screening of EM markets for potential risk, the central bank reserve to GDP ratio is easy to calculate. It will not reveal the exact timing of a currency depreciation but it is an excellent sanity check when one is tempted, for other reasons, to invest.
Last year Turkey and Argentina both saw a sudden depreciation, but, with the Federal Reserve now indicating that its tightening phase may have run its course, now is the time to look for value even among the casualties of the Fed. India is, of course, my long-term EM of choice, but as a shorter-term, speculative, recovery trade Turkish or Argentine bonds are worthy of consideration. With inverted curves, shorter duration bonds are their own reward. Argentine 4yr bonds spiked to yield 36% in November and currently offer a 33% yield. Turkish 1yr bonds are even more beguiling, they spiked to a yield of 32% in October but still offer a 22% return. Momentum still favours a short exposure so there is time to take advantage of these elevated returns.
Macro Letter – No 103 – 26-10-2018
Not waving but drowning – Stocks, debt and inflation?
The recent decline in the US stock market, after the longest bull-market in history, has prompted many commentators to focus on the negative factors which could sow the seeds of the next recession. Among the main concerns is the inexorable rise in debt since the great financial recession (GFR) of 2008. According to May 2018 data from the IMF, global debt now stands at $63trln, with emerging economy debt expansion, over the last decade, more than offsetting the marking time among developed nations. The IMF – Global Debt Database: Methodology and Sources WP/18/111 – looks at the topic in more detail.
The title of this week’s Macro letter comes from the poet Stevie Smith: –
I was much further out than you thought
And not waving but drowning.
It seems an appropriate metaphor for valuation and leverage in asset markets. In 2013 Thomas Pickety published ‘Capital in the 21st Century’ in which he observed that income inequality was rising due to the higher return on unearned income relative to labour. He and his co-authors gathering together one of the longest historical data-set on interest rates and wages – an incredible achievement. Their conclusion was that the average return on capital had been roughly 5% over the very long run.
This is not the place to argue about the pros and cons of Pickety’s conclusions, suffice to say that, during the last 50 years, inflation indices have tended to understate what most of us regard as our own personal inflation rate, whilst the yield offered by government bonds has been insufficient to match the increase in our cost of living. The real rate of return on capital has diminished in the inflationary, modern era. Looked at from another perspective, our current fiat money and taxation system encourages borrowing rather than lending, both by households, corporates, for whom repayment is still an objective: and governments, for whom it is not.
Financial innovation and deregulation has helped to oil the wheels of industry, making it easier to service or reschedule debt today than in the past. The depth of secondary capital markets has made it easier to raise debt (and indeed equity) capital than at any time in history. These financial markets are underpinned by central banks which control interest rates. Since the GFR interest rates have been held at exceptionally low levels, helping to stimulate credit growth, however, that which is not seen, as Bastiat might have put it, is the effect that this credit expansion has had on the global economy. It has led to a vast misallocation of capital. Companies which would, in an unencumbered interest rate environment, have been forced into liquidation, are still able to borrow and continue operating; their inferior products flood the market place crowding out the market for new innovative products. New companies are confronted by unfair competition from incumbent firms. Where there should be a gap in the market, it simply does not exist. At a national and international level, productivity slows and the trend rate of GDP growth declines.
We are too far out at sea and have been for decades. Markets are never permitted to clear, during economic downturns, because the short-term pain of recessions is alleviated by the rapid lowering of official interest rates, prolonging the misallocation of capital and encouraging new borrowing via debt – often simply to retire equity capital and increase leverage. The price of money should be a determinant of the value of an investment, but when interest rates are held at an artificially low rate for a protracted period, the outcome is massively sub-optimal. Equity is replaced by debt, leverage increases, zombie companies limp on and, notwithstanding the number of technology start-ups seen during the past decade, innovation is crushed before it has even begun.
In an unencumbered market with near price stability, as was the case prior to the recent inflationary, fiat currency era, I suspect, the rate of return on capital would be approximately 5%. On that point, Pickety and I are in general agreement. Today, markets are as far from unencumbered as they have been at any time since the breakdown of the Bretton Woods agreement in 1971.
Wither the stock market?
With US 10yr bond yields now above 3%, stocks are becoming less attractive, but until real-yields on bonds reach at least 3% they still offer little value – US CPI was at 2.9% as recently as August. Meanwhile higher oil prices, import tariffs and wage inflation all bode ill for US inflation. Nonetheless, demand for US Treasuries remains robust while real-yields, even using the 2.3% CPI data for September, are still exceptionally low by historic standards. See the chart below which traces the US CPI (LHS) and US 10yr yields (RHS) since 1971. Equities remain a better bet from a total return perspective: –
Source: Trading Economics
What could change sentiment, among other factors, is a dramatic rise in the US$, an escalation in the trade-war with China, or a further increase in the price of oil. From a technical perspective the recent weakness in stocks looks likely to continue. A test of the February lows may be seen before the year has run its course. Already around ¾ of the stocks in the S&P 500 have suffered a 10% plus correction – this decline is broad-based.
Many international markets have already moved into bear territory (declining more than 20% from their highs) but the expression, ‘when the US sneezes the world catches a cold,’ implies that these markets may fall less steeply, in a US stock downturn, but they will be hard-pressed to ignore the direction of the US equity market.
Conclusions and investment opportunities
Rumours abound of another US tax cut. Federal Reserve Chairman, Powell, has been openly criticised by President Trump; whilst this may not cause the FOMC to reverse their tightening, they will want to avoid going down in history as the committee that precipitated an end to Federal Reserve independence.
There is a greater than 50% chance that the S&P 500 will decline further. Wednesday’s low was 2652. The largest one month correction this year is still that which occurred in February (303 points). We are not far away, however, a move below 2637 will fuel fears. I believe it is a breakdown through the February low, of 2533, which will prompt a more aggressive global move out of risk assets. The narrower Dow Jones Industrials has actually broken to new lows for the year and the NASDAQ suffered its largest one day decline in seven years this week.
A close below 2352 for the S&P 500 would constitute a 20% correction – a technical bear-market. If the market retraces to the 2016 low (1810) the correction will be 38% – did someone say, ‘Fibonacci’ – if we reach that point the US Treasury yield curve will probably be close to an inversion: and from a very low level of absolute rates. Last week the FRBSF – The Slope of the Yield Curve and the Near-Term Outlook – analysed the recession predicting power of the shape of the yield curve, they appear unconcerned at present, but then the current slope is more than 80bp positive.
If the stock correction reaches the 2016 lows, a rapid reversal of Federal Reserve policy will be required to avoid accusations that the Fed deliberately engineered the disaster. I envisage the Fed calling upon other central banks to render assistance via another concert party of quantitative, perhaps backed up by qualitative, easing.
At this point, I believe the US stock market is consolidating, an immanent crash is not on the horizon. The GFR is still too fresh in our collective minds for history to repeat. Longer term, however, the situation looks dire – history may not repeat but it tends to rhyme. Among the principal problems back in 2008 was an excess of debt, today the level of indebtedness is even greater…
We are much further out than we thought,
And not waving but drowning.
Macro Letter – No 96 – 04-05-2018
Is the US exporting a recession?
After last week’s ECB meeting, Mario Draghi gave the usual press conference. He confirmed the continuance of stimulus and mentioned the moderation in the rate of growth and below-target inflation. He also referred to the steady expansion in money supply. When it came to the Q&A he revealed rather more:-
It’s quite clear that since our last meeting, broadly all countries experienced, to different extents of course, some moderation in growth or some loss of momentum. When we look at the indicators that showed significant, sharp declines, we see that, first of all, the fact that all countries reported means that this loss of momentum is pretty broad across countries.
It’s also broad across sectors because when we look at the indicators, it’s both hard and soft survey-based indicators. Sharp declines were experienced by PMI, almost all sectors, in retail, sales, manufacturing, services, in construction. Then we had declines in industrial production, in capital goods production. The PMI in exports orders also declined. Also we had declines in national business and confidence indicators.
I quote this passage out of context because the entire answer was more nuanced. My reason? To highlight the difference between the situation in the EU and the US. In Europe, money supply (M3) is growing at 4.3% yet inflation (HICP) is a mere 1.3%. Meanwhile in the US, inflation (CPI) is running at 2.4% and money supply (M2) is hovering a fraction above 2%. Here is a chart of Eurozone M3 since 1999:-
The recent weakening of momentum is a concern, but the absolute level is consistent with a continued expansion.
Looked at over a rather longer time horizon, here is a chart of US M2 since 1900:-
Source: Hoisington Asset Management, Federal Reserve
The letters A, B, C, D denote the only occasions, during the last 118 years, when a decline in the expansion (or, during the 1930’s, contraction) of M2 did not lead to a recession. 17 out of 21 is a quite compelling record.
Another concern for markets is the flatness of the US yield curve. Here is the 2yr – 10yr yield differential since 1990:-
Source: Factset, Mauldin Economics
More importantly, for international borrowers, the 6-month LIBOR rate has risen by more than 60 basis points since the start of the year (from 1.8% to 2.5%) whilst 30yr Swap rates have increased by only 40 basis points (2.6% to 3%). The 10yr – 30yr Swap curve is now practically flat.
Also worthy of comment, as US Treasury yields have risen, the relationship between Bonds and Swaps has begun to normalise – 30yr T-Bond yields are only 40 basis points above their level of January and roughly at the same level as in the spring of last year. In April 2017 I wrote in Macro Letter – No 74 – US 30yr Swaps have yielded less than Treasuries since 2008 – does it matter?:-
Today the IRS market increasingly determines the cost of finance, during the next crisis IRS yields may rise or fall by substantially more than the same maturity of US T-bond, but that is because they are the most liquid instruments and are only indirectly supported by the Central Bank.
It looks like I may have to eat my words, here is the Bond vs Swap table revisited:-
Source: Investing.com, Interestrateswaps.com, BBA
What is evident is that the Bond/Swap inversion in the longer maturities has closed substantially even as shorter maturity spreads have narrowed. Federal Reserve policy has been the dominate factor.
Why is it, however, that the effect of higher US rates is, seemingly, felt more poignantly in Europe than the US? Does this bring us back to protectionism? Perhaps, but in less contentious terms, the US has run a capital account surplus for many years. Outside the US investment is closely tied to LIBOR financing costs, these have remained higher, except in the longest maturities, and these rates have risen most precipitously this year. Looked at another way, the higher interest rate policies of the Federal Reserve, despite the continued largesse of other central banks, is exporting the next recession to the rest of the world.
I ended Macro Letter – No 74 back in April 2017 – saying:-
Meanwhile, although interest rates have risen from historic lows they remain far below their long run average. Pension funds and other long-term investors still require 7% or more in annualised returns in order to meet their liabilities. They are being forced to continuously increase their investment risk and many have chosen to use the swap market. The next crisis is likely to see an even more pronounced unravelling than in 2008/2009. The unravelling may not happen for some while but the stresses are likely to be focused on the IRS market.
One year on, cracks in the capital markets edifice are beginning to become more evident. GDP growth has started to rollover in the US, Eurozone and Japan. Yields are still relatively low but the absolute increase in rates for shorter maturities (e.g. the near doubling of US 2yr yields from 1.25% to 2.5% in a single year) is guaranteed to take its toll on corporate interest servicing costs. US capital markets are the envy of the world. They are deep and allow borrowers to finance far into the future. The rest of the world is forced to borrow at shorter tenors. A three basis point narrowing of 5yr spreads between Swaps and Bonds is hardly compensation for the near 1% increase in interest rates, or, put in starker terms, a 46% increase in absolute borrowing costs.
Conclusion and investment opportunities
How is the rise in borrowing costs impacting the US stock market? Volatility is back, but earnings are robust. Factset – S&P 500 Earnings Season Update: April 27, 2018 – described it thus:-
To date, 53% of the companies in the S&P 500 have reported actual results for Q1 2018. In terms of earnings, more companies are reporting actual EPS above estimates (79%) compared to the five-year average. If 79% is the final percentage for the quarter, it will mark the highest percentage of S&P 500 companies reporting actual EPS above estimates since FactSet began tracking this metric in Q3 2008. In aggregate, companies are reporting earnings that are 9.1% above the estimates, which is also above the five-year average. In terms of sales, more companies (74%) are reporting actual sales above estimates compared to the five-year average. In aggregate, companies are reporting sales that are 1.7% above estimates, which is also above the five-year average. If 1.7% is the final percentage for the quarter, it will mark the largest revenue surprise percentage since FactSet began tracking this metric in Q3 2008.
… The blended (combines actual results for companies that have reported and estimated results for companies that have yet to report), year-over-year earnings growth rate for the first quarter is 23.2% today, which is higher than the earnings growth rate of 18.5% last week. Positive earnings surprises reported by companies in multiple sectors (led by the Information Technology sector) were responsible for the increase in the earnings growth rate for the index during the past week. All 11 sectors are reporting year-over-year earnings growth. Nine sectors are reporting double-digit earnings growth, led by the Energy, Materials, Information Technology, and Financials sectors.
We are more than halfway through Q1 earnings (I’m writing this letter on Wednesday 2nd May). Results have generally been above forecast and now the Fed seems conscious that they must not be too hasty to reverse the effects of both zero rates and QE. Added to which, while US stocks have been languishing mid-range, European stocks have recently broken out of their recent ranges to the upside, despite discouraging economic data.
The US stock market looks less expensive than it did in January 2017, when I wrote Macro Letter – 68 – Equity valuation in a de-globalising world. Then I was looking for stock markets with a low correlation to the US: they were (and remain) hard to find.
Other indicators to watch which exert a strong influence on stocks include the US PMI Index – last at 54.8 up from 54.2 in March. Above 50 there is little cause for concern. For the Eurozone it is even higher at 55.2, whilst throughout G20 no economy is recording a PMI below 50.
The chart below shows the Citigroup Economic Surprises Index (blue) vs the S&P500 Forward P/E estimates (red):-
Source: Yardeni Research, S&P, Thompson Reuters, Citigroup
Economic surprises remain positive rather than negative for the US. In the Eurozone it is quite another matter:-
Source: Bloomberg, Citigroup
A number of economic indicators are pointing to a slowdown, yet US stocks are beating estimates. To judge from price action, the market appears to be unimpressed by earnings. I am reminded of the old adage, ‘When all the buyers are in the market it’s time to sell.’ From a technical perspective it makes sense to be patient, but the market has failed to rise substantially on a positive slew of earnings news. This may be because there is a more important factor driving sentiment: the direction of US rates. It certainly appears to have engendered a revival of the US$. It rallied last month having been in a downtrend since January 2017 despite a steadily tightening Federal Reserve. For EURUSD the move from 1.10 to 1.25 appears to have taken its toll. On the basis of the CESI chart, above, if Wall Street sneezes, the Eurozone might catch pneumonia.