Gold – is it all that glisters?

Gold – is it all that glisters?

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Macro Letter – No 116 – 14-06-2019

Gold – is it all that glisters?

  • Uncertainty about US trade policy has truncated the rally in stocks
  • Gold remains supported by central bank buying and fears of a US$ collapse
  • Gold miners look best placed to reap the benefits regardless of direction
  • A collapse in the U$ is needed for gold to rally substantially

In Q4 2018, as stocks declined, gold rallied 8.1% and gold mining stocks 13.7%. It was a prescient reminder of the value of gold as a portfolio diversifier. There have, however, been some other developments both for gold and gold mining stocks which are worthy of closer investigation.

Central Banks

Central bank net purchases of gold reached 651.5 tons in 2018, up 74% from 2017, when 375 tons were bought. The Russian central bank, perhaps fearing US sanctions, sold almost all of its US Treasury bonds to buy 274.3 tons of gold last year. For probably similar reasons, the Turkish central bank bought 51.5 tons, down from the 88 tons purchased the previous year. Other big central bank buyers included Kazakhstan, India, Iraq, Poland and Hungary.

In the first quarter of 2019 central banks purchased a further 145.5 tons, up 68% on Q1 2018. The trend is not new, central bank purchases have been rising since 2009: –

Central Banks Gold Holdings - BIS, IMF GEMS, Reuters

Source: BIS, IMF, GEMS, Reuters

Putting global reserve holdings in perspective, here is the central bank world ranking as at March 2019: –

statistic_id267998_value-of-gold-reserves-2019-by-country

Source: IMF, Statistica

Despite the substantial buying from central banks the price of gold has been broadly range bound for the past five years.

commodity-gold 10 year

Source: Trading Economics

The absence of a sustained rally suggests that many investors have forsaken the barbarous relic, however, concern that the gold price will collapse have to be tempered by the cost of mining an ounce of gold. Mining costs have increased substantially since the early 2000’s due to increasingly expensive exploration costs and a general decline in ore quality. In the chart below Money Metals Exchange shows Barrick (GOLD) and Newmont (NEM) average cost of production since 2000: –

saupload_Barrick-Newomnt-Production-Cost-vs-Gold-Price_thumb1

Source: SRSrocco Report, Kitco

In a July 2018 post for Seeking Alpha – Money Metals Exchange –  Never Before Seen Charts: Gold Mining Industry’s Costs Are Higher Than Market Realizes show that the amount of ore needed to produce an ounce of gold at Barrick’s (GOLD) Nevada Goldstrike and Cortez Mines has increased four-fold since 1998: –

saupload_barrick-nevada-goldstrike-cortez-mines

Source: SRSrocco Report, Barrick

The market capitalisation of the sector has halved since 2012, leading to understandable consolidation and deleveraging. Gold, however, is an unusual commodity in that its stock is far larger than its annual production. About 3000 tons of gold is mined annually, this is dwarfed by the 190,000 tons that have been mined throughout history according to World Gold Council estimates. Since it has little industrial use, almost all the gold ever mined remains in existence: central bank reserves are a key determinant of its price. Interesting research on the subject of what drives gold prices can be found in this article from the London Bullion Market Association – Do Extraction Costs Drive Gold Prices? They conclude that, due to the large stock relative to production, the price of gold is the principal influence on the mining industry.

The US$ and inflation expectations

The rally in the gold price in 2011-2012 was linked to the Eurozone crisis, the moderation since then has coincided with a recovery in the US Dollar Index. Other factors which traditionally drive gold higher include inflation expectations, these fears have continually failed to materialise whilst the inexorable increase in debt has led some to speculate about a debt deflation spiral; an environment in which gold would not be expected to excel: –

united-states-currency DXY 2000 - 2019

Source: Trading Economics

A different approach to gold valuation is the ratio of the gold price to the total-return index for ten-year US government bonds. This ratio has been moving steadily higher, suggesting a shift to an era of structural inflation, according to Gavekal Research. Other evidence of inflation remains muted, however.

Is gold perfectly priced or do the central banks know something we do not?

A look back at the decade after the end of gold reserve standard is a good starting point. The Bretton Woods agreement collapsed in 1971. In the years that followed currency fluctuations were substantial and the US$ lurched steadily lower: –

USD Index 1971 - 1981

Source: Trading Economics

The US$ was so little revered that in 1978 the US Treasury had to issue foreign currency denominated Carter Bonds in Swiss Francs and German Marks, such was the level of distrust in the mighty greenback.

Confidence was finally restored when Paul Volker took the helm of the Federal Reserve. Volker did what his predecessor but three, William McChesney Martin, had only talked about – taking away the punch bowl just as the party got started – he hiked interest rates and managed to subdue inflation: the fiat US$ was back in favour.

Today the US$ is undoubtedly the first reserve currency. In the era of digital money and crypto currencies the barbarous relic has stiff competition. Added to which it is traditionally an unexpected inflation hedge and traditionally affords scant protection in a deflationary environment. Given the global overhang of US$ denominated debt, many believe this is the next challenge to the international order.

Considering the conflagration of factors alluded to above, I believe gold is destined to remain a much watched side-line. Gold mining stocks may fare better, as S&P Global Market Intelligence – Outlook 2019: US$3.9B Increase In Earnings For Majors – explains: –

…rising production in 2019, higher metals prices and lower costs could increase free cash flow by US$1.3 billion, or 19%, year over year. Companies will use this increased cash flow to lower net debt, which is expected to fall 19% year over year in 2019, placing the majors at their lowest level of leverage in five years. The majors have been focusing on returns to shareholders. Higher earnings have led to dividend payouts increasing 103% to US$2.0 billion in 2017 from US$1.0 billion in 2016 and remaining at about US$2.0 billion in 2018.

As for price of gold itself? The attractive fundamentals underpinning mining stocks is likely to cap the upside, whilst continued central bank buying will insure the downside is muzzled too. When I have little fundamental conviction I am inclined to follow the trend. A break to the upside maybe closer, but the long period of price consolidation favours a break to the downside in the event of a global crisis.

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Debasing the Baseless – Modern Monetary Theory

Debasing the Baseless – Modern Monetary Theory

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Macro Letter – No 114 – 10-05-2019

Debasing the Baseless – Modern Monetary Theory

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

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

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

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

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

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

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

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

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

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

A prelude to MMT

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

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

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

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

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

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

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

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

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

G − T = S – I

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

In other words…

Government Budget Deficit = Net Private Saving

wraybook

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

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

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

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

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

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

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

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

Conclusion and Investment Opportunities

The radical ideas contained in MMT are unlikely to be adopted in full, but the idea that fiscal expansion is non-inflationary provides succour to profligate politicians of all stripes. Come the next hint of recession, central banks will embark on even more pronounced quantitative and qualitative easing, safe in the knowledge that, should they fail to reignite their economies, government mandated fiscal expansion will come to their aid. Long-term bond yields will head towards the zero-bound – some are there already. Debt to GDP ratios will no longer trouble finance ministers. If stocks decline, central banks will acquire them: and, in the process, the means of production. This will be justified as the provision of permanent capital. Bonds will rise, stocks will rise, real estate will rise. There will be no inflation, except in the price of assets.

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

A global slowdown in 2019 – is it already in the price?

A global slowdown in 2019 – is it already in the price?

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Macro Letter – No 106 – 07-12-2018

A global slowdown in 2019 – is it already in the price?

  • US stocks have given back all of their 2018 gains
  • Several developed and emerging stock markets are already in bear-market territory
  • US/China trade tensions have eased, a ‘No’ deal Brexit is priced in
  • An opportunity to re-balance global portfolios is nigh

The recent shakeout in US stocks has acted as a wake-up call for investors. However, a look beyond the US finds equity markets that are far less buoyant despite no significant tightening of monetary conditions. In fact a number of emerging markets, especially some which loosely peg themselves to the US$, have reacted more violently to Federal Reserve tightening than companies in the US. I discussed this previously in Macro Letter – No 96 – 04-05-2018 – Is the US exporting a recession?

In the wake of the financial crisis, European lacklustre growth saw interest rates lowered to a much greater degree than in the US. Shorter maturity German Bund yields have remained negative for a protracted period (7yr currently -0.05%) and Swiss Confederation bonds have plumbed negative yields never seen before (10yr currently -0.17%, but off their July 2016 lows of -0.65%). Japan, whose stock market peaked in 1989, remains in an interest rate wilderness (although a possible end to yield curve control may have injected some life into the market recently) . The BoJ balance-sheet is bloated, yet officials are still gorging on a diet of QQE policy. China, the second great engine of world GDP growth, continues to moderate its rate of expansion as it transitions away from primary industry and towards a more balanced, consumer-centric economic trajectory. From a peak of 14% in 2007 the rate has slowed to 6.5% and is forecast to decline further:-

china-gdp-growth-annual 1988 - 2018

Source: Trading Economics, China, National Bureau of Statistics

2019 has not been kind to emerging market stocks either. The MSCI Emerging Markets (MSCIEF) is down 27% from its January peak of 1279, but it has been in a technical bear market since 2008. The all-time high was recorded in November 2007 at 1345.

MSCI EM - 2004 - 2018

Source: MSCI, Investing.com

A star in this murky firmament is the Brazilian Bovespa Index made new all-time high of 89,820 this week.

brazil-stock-market 2013 to 2018

Source: Trading Economics

The German DAX Index, which made an all-time high of 13,597 in January, lurched through the 10,880 level yesterday. It is now officially in a bear-market making a low of 10,782. 10yr German Bund yields have also reacted to the threat to growth, falling from 58bp in early October to test 22bp yesterday; they are down from 81bp in February. The recent weakness in stocks and flight to quality in Bunds may have been reinforced by excessively expansionary Italian budget proposals and the continuing sorry saga of Brexit negotiations. A ‘No’ deal on Brexit will hit German exporters hard. Here is the DAX Index over the last year: –

germany-stock-market 1yr

Source: Trading Economics

I believe the recent decoupling in the correlation between the US and other stock markets is likely to reverse if the US stock market breaks lower. Ironically, China, President Trump’s nemesis, may manage to avoid the contagion. They have a command economy model and control the levers of state by government fiat and through currency reserve management. The RMB is still subject to stringent currency controls. The recent G20 meeting heralded a détente in the US/China trade war; ‘A deal to discuss a deal,’ as one of my fellow commentators put it on Monday.

If China manages to avoid the worst ravages of a developed market downturn, it will support its near neighbours. Vietnam should certainly benefit, especially since Chinese policy continues to favour re-balancing towards domestic consumption. Other countries such as Malaysia, should also weather the coming downturn. Twin-deficit countries such as India, which has high levels of exports to the EU, and Indonesia, which has higher levels of foreign currency debt, may fare less well.

Evidence of China’s capacity to consume is revealed in recent internet sales data (remember China has more than 748mln internet users versus the US with 245mln). The chart below shows the growth of web-sales on Singles Day (11th November) which is China’s equivalent of Cyber Monday in the US: –

China Singles day sales Alibaba

Source: Digital Commerce, Alibaba Group

China has some way to go before it can challenge the US for the title of ‘consumer of last resort’ but the official policy of re-balancing the Chinese economy towards domestic consumption appears to be working.

Here is a comparison with the other major internet sales days: –

Websales comparison

Source: Digital Commerce, Adobe Digital Insights, company reports, Internet Retailer

Conclusion and Investment Opportunity

Emerging market equities are traditionally more volatile than those of developed markets, hence the, arguably fallacious, argument for having a reduced weighting, however, those emerging market countries which are blessed with good demographics and higher structural rates of economic growth should perform more strongly in the long run.

A global slowdown may not be entirely priced into equity markets yet, but fear of US protectionist trade policies and a disappointing or protracted resolution to the Brexit question probably are. In financial markets the expression ‘buy the rumour sell that fact’ is often quoted. From a technical perspective, I remain patient, awaiting confirmation, but a re-balancing of stock exposure, from the US to a carefully selected group of emerging markets, is beginning to look increasingly attractive from a value perspective.

The Self-righting Ship – Debt, Inflation and the Credit Cycle

The Self-righting Ship – Debt, Inflation and the Credit Cycle

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Macro Letter – No 105 – 23-11-18

The Self-righting Ship – Debt, Inflation and the Credit Cycle

recovery_saltaire

Source: Stromness Lifeboat

  • Rising bond yields may already have tempered economic growth
  • Global stocks are in a corrective phase but not a bear-market
  • With oil prices under pressure inflation expectations have moderated

The first self-righting vessel was a life-boat, designed in 1789. It needed to be able to weather the most extreme conditions and its eventual introduction (in the 1840’s) transformed the business of recuse at sea forever. The current level of debt, especially in the developed economies, seems to be acting rather like the self-righting ship. As economic growth accelerates and labour markets tighten, central banks gradually tighten monetary conditions in expectation of inflation. As short-term rates increase, bond yields follow, but, unlike the pattern seen in the higher interest rate era of the 1970’s and 1980’s, the effect of higher bond yields quickly leads to a tempering of credit demand.

Some commentators will rightly observe that this phenomenon has always existed, but, at the risk of saying this time it’s different, the level at which higher bond yields act as a break on credit expansion are much lower today in most developed markets.

When in doubt, look to Japan

For central bankers, Japan is the petri dish in which all unconventional monetary policies are tested. Even today, QQE – Quantitative and Qualitative Easing – is only seriously being undertaken in Japan. The Qualitative element, involving the provision of permanent capital by the Bank of Japan (BoJ) through their purchases of common stocks (at present, still, indirectly via ETFs), remains avant garde even by the unorthodox standards of our times.

Recently the BoJ has hinted that it may abandon another of its unconventional monetary policies – yield curve control. This is the operation whereby the bank maintains rates for 10yr maturity JGBs in a range of between zero and 10 basis point – the range is implied rather than disclosed – by the purchase of a large percentage of all new Japanese Treasury issuance, they also intervene in the secondary market. During the past two decades, any attempt, on the part of the BoJ, to reverse monetary easing has prompted a rise in the value of the Yen and a downturn in economic growth, this time, however, might be different – did I use that most dangerous of terms again? It is a long time since Japanese banks were able to function in a normal manner, by which I mean borrowing short and lending long. The yield curve is almost flat and any JGBs with maturities shorter than 10 years tend to trade with negative yields in the secondary market.

Japanese banks were not heavily involved in the boom of the mid-2000’s and therefore weathered the 2008 crisis relatively well. Investing abroad has been challenging due to the continuous rise in the value of the Yen, but during the last few years the Japanese currency has begun to trade in a broad range rather than appreciating inexorably.

In the non-financial sector a number of heavily indebted companies continue to limp on, living beyond their useful life on a debt-fuelled last hurrah. Elsewhere, however, Japan has a number of world class companies trading at reasonable multiples to earnings. If the BoJ allows rates to rise the zombie corporations will finally exit the gene pool and new entrepreneurs will be able to fill the gap created in the marketplace more cheaply and to the benefit of the beleaguered Japanese consumer. My optimism about a sea-change at the BoJ may well prove misplaced. Forsaking an inflation target and offering Japanese savers positive real-interest rates is an heretically old-fashioned idea.

Whilst for Japan, total debt consists mainly of government obligations, for the rest of the developed world, the distribution is broader. Corporate and consumer borrowing forms a much larger share of the total sum. Giving the historically low level of interest rates in most developed economies today, even a moderate rise in interest rates has an immediate impact. Whereas, in the 1990’s, an increase from 5% to 10% mortgage rates represented a doubling payments by the mortgagee, today a move from 2% to 4% has the same impact.

The US stock market as bellwether for global growth

Last month US stocks suffered a sharp correction. The rise had been driven by technology and it was fears of a slowdown in the technology sector that precipitated the rout. Part of the concern also related to US T-Bonds as they breached 3% yields – a level German Bund investors can only dream of. Elsewhere stock markets have been in corrective (0 – 20%) or bear-market (20% or more) territory for some time. I wrote about this decoupling in Macro Letter – No 101 – 31-08-2018 – Divergent – the breakdown of stock market correlations, temp or perm? Now the divergence might be about to reverse. US stocks have yet to correct, whilst China and its vassals have already reacted to the change in global growth expectations. Globally, stocks have performed well for almost a decade: –

MSCI World

Source: MSCI and Yardeni

The next decade may see a prolonged period of range trading. After 10 years, during which momentum investing has paid handsomely, value investing may be the way to navigate the next.

Along with stocks, oil prices have fallen, despite geopolitical tensions. The Baker Hughes rig count reached 888 this week, the highest since early 2015. With WTI still above $60/bbl, the number of active rigs is likely to continue growing.

US 10yr bond yields have already moderated (down to 3.06% versus their high of 3.26%) and stocks have regained some composure after the sudden repricing of last month. The ship has self-righted for the present but the forecast remains turbulent.     

Not waving but drowning – Stocks, debt and inflation?

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Macro Letter – No 103 – 26-10-2018

Not waving but drowning – Stocks, debt and inflation?

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

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

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

I was much further out than you thought

And not waving but drowning.

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

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

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

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

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

Wither the stock market?

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

united-states-inflation-cpi 1970 to 2018

Source: Trading Economics

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

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

Conclusions and investment opportunities

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

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

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

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

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

We are much further out than we thought,

And not waving but drowning.