Tag Archives: Japan

The Mechanics of Absurdity

Over the past few decades, the central banks, including the Federal Reserve (Fed), have relied increasingly on interest rates to help modify economic growth. Interest rate management is their tool of choice because it can be effective and because central banks regulate the supply of money, which directly effects the cost to borrow it. Lower interest rates incentivize borrowers to take on debt and consume while dis-incentivizing savings.

Regrettably, a growing consequence of favoring lower than normal interest rates for prolonged periods is that consumers, companies, and nations grow increasingly indebted as a percentage of their respective income. In many cases, consumption is pulled from the future to the present day. Accordingly, less consumption is needed in the future and a larger portion of income and wealth must be devoted to servicing the accumulated debt as opposed to productive ventures which would otherwise generate income to help pay off the debt.

Today, interest rates are at historically low levels around the globe. Interest rates are negative in Japan and throughout much of Europe. In this article, we expound on the themes laid out in Negative is the New Subprime, to discuss the mechanics of negative-yielding debt as well as the current mindset of investors that invest in negative-yielding debt.

Is invest the right word in describing an asset that when held to maturity guarantees a loss of capital?

Negative Yield Mechanics

Negative yields are not only bestowed upon sovereign debt, as investment grade and even some junk-rated debt in Europe now carry negative yields. Even stranger, Market Watch just wrote about a Danish bank offering consumers’ negative interest rate mortgages (LINK).

You might be thinking, “Wow, I can take out a negative interest rate loan, receive payments every month or quarter and then pay back what was lent to me?” That is not how it works, at least not yet. Below are two examples that walk through the lender and borrower cash flows for negative-yielding debt.

Some of the bonds trading at negative yields were issued when yields were positive and therefore have coupon payments. For example, in August of 2018, Germany issued a 30 year bond with a coupon of 1.25%. The price of the bond is currently $143, making the yield to maturity -0.19%. Today, it will cost you $14,300 to buy $10,000 face value of the bond. Going forward, you will receive coupon payments of $125 a year and ultimately receive $10,000 in 2048. Over the next 29 years you will receive $3,625 in coupon payments but lose $4,300 in principal, hence the current negative yield to maturity.

Bonds issued with a zero coupon with negative yields are similar in concept but the mechanics are slightly different than our positive coupon example from above. Germany issued a ten-year bond which pays no coupon. Currently, the price is 106.76, meaning it will cost an investor $10,676 to buy $10,000 face value of the bond. Over the next ten years the investor will receive no coupon payments, and at the end of the term they will receive $10,000, resulting in a $676 loss. The lower the negative yield to maturity, the higher premium to par and the greater loss of principal at maturity.

We suspect that example two, the zero-coupon bond issued at a price above par, will be the issuance model going forward for negative yielding bonds.

Why?

At this point, after reviewing the cash flows on the German bonds, you are probably asking why an investor would make an investment in which they are almost guaranteed to lose money. There are two predominant reasons worth exploring.

Safety: Investors that store physical gold in a gold vault pay a fee for safe storage. Individuals with expensive jewelry or other keepsakes pay banks a fee to use their vaults. Custodians, such as Fidelity or Schwab, are paid fees for the safekeeping of our stocks and bonds.

Storing money, as a deposit in a bank, is a little different from the prior examples. While banks are a safer place to store money than a personal vault, mattress, or wallet, the fact is that deposits are loans to the bank. Banks traditionally pay depositors an interest rate so that they have funds they can lend to borrowers at higher rates than the rate incurred on the deposit.

With rates negative in Europe and Japan, their respective central banks have essentially made the storing of deposits with banks akin to the storage of gold, jewelry, and stocks – they are subject to a safe storage fee.  Unfortunately, many people and corporations have no choice but to store their money in negative-yielding instruments and must lend money to a bank and pay a “storage fee.”  

On a real return basis, in other words adjusted for inflation, whether an investor comes out ahead by lending in a negative interest rate environment, depends on changes to the cost of living during that time frame. Negative yielding bonds emphatically signal that Germany will be in a deflationary state over the next ten years. With global central bankers taking every possible step, legal and otherwise, to avoid deflation and generate inflation, betting on deflation via negative yielding instruments seems like a poor choice for investors.

Greater Fool Theory: Buying a zero-coupon bond for 101 today with the promise of receiving 100 is a bad investment. Period. Buying the same bond for 101 today and selling it for 102 tomorrow is a great investment. As yields continue to fall further into negative territory, the prices of bonds rise. While the buyer of a negative-yielding bond may not receive a coupon, they can still profit, and sometimes appreciably as yields decline.

This type of trade mindset falls under the greater fool theory. Per Wikipedia:

“In finance and economics, the greater fool theory states that the price of an object is determined not by its intrinsic value, but rather by irrational beliefs and expectations of market participants. A price can be justified by a rational buyer under the belief that another party is willing to pay an even higher price. In other words, one may pay a price that seems “foolishly” high because one may rationally have the expectation that the item can be resold to a “greater fool” later.”

More succinctly, someone buying a bond that guarantees a loss can profit if they can find someone even more willing to lose money.

Scenario Analysis

Let’s now do a little scenario analysis to understand the value proposition of holding a negative-yielding bond.

For all three examples we use a one year bond to keep the math simple. The hypothetical bond details are as follows:

  • Issue Date: 9/1/2019
  • Maturity Date: 9/1/2020
  • Coupon = 0%
  • Yield at Issuance: -1.0%
  • Price at Issuance: 101.00

Greater fool scenario: In this scenario, the bondholder buys the new issue bond at 101 and sells it a week later at 101.50. In this case, the investor makes a .495% return or almost 29% annualized.

Normalization: This next scenario assumes that yields return to somewhat normal levels and the holder sells the bond in six months.If the yield returns to zero in six months, the price of the bond would fall to 100. In this case, our investor, having paid 101.00, will lose 1% over the six month period or 2% annualized.

Hold to maturity: If the bond is held to maturity, the bondholder will be redeemed at par losing 1% as they are paid $100 at maturity on a bond they purchased for $101.

Summary

Writing and thinking about the absurdity of negative yields is taxing and unnatural. It forces us to contemplate basic financial concepts in ways that defy common sense and rational thought. This is not a pedantic white paper discussing hypothetical central bank magic tricks and sleight of hand; this is about something occurring in real-time.

Excessive monetary policy has been the crutch of growth for decades spurred by an intense desire to avoid and minimize otherwise healthy and routine economic corrections. It was fueled by the cult of personality which took over in the 1990s when Alan Greenspan was labeled “The Maestro”. He, Robert Rubin, and Lawrence Summers were christened “The Committee to Save the World” by Time magazine in February 1999.  Greenspan was then the subject of a biography by famed Watergate journalist Bob Woodward infamously titled Maestro in 2000.

Under Greenspan and then Bernanke, Yellen and now Powell, rational monetary policy and acknowledgement of naturally occurring business cycles has taken a back seat to avoidance of these economic cycles at all cost. As a result, central bankers around the world are trying justify the inane logic of negative rates.

RIA Pro Economic Update

Tracking global and domestic economic conditions and forming future expectations of economic activity plays a large role in our investment and risk management process. As such we update you on current global and domestic economic trends.

China

China is the world’s second-largest economy and, per the IMF, responsible for nearly 30% of global growth. On January 20, 2019, China reported its GDP rose 6.6% in the fourth quarter. While the growth rate may appear strong, it is the weakest since the first quarter of 2009 and continues a gradual trend lower. The weakening GDP growth has been further confirmed via various purchasing manager surveys, trade data and auto sales which point to a further slowing of growth.

Given their size, growing at such an outsized rate in the future is near impossible. Making matters worse, much of the credit stimulus used to promote activity in years past is becoming a headwind to growth. We expect growth to continue slowing in China which will weigh on global economic activity. In the short run, there are two wild cards we are following closely. First, how will trade negotiations affect China’s economy? Second, will China flood the economy with monetary and fiscal stimulus as they did in 2015/2016 to avoid a further slowdown? As we have seen repeatedly since 2008, the amount and type of stimulus that China applies to their economy and markets are of great importance to global financial markets.

Japan

Japan, the world’s third-largest economy, has been experiencing weakness for over a year. In fact, the first and third quarters of 2018 both saw negative GDP growth. High levels of debt and poor demographics do not bode well for economic growth in Japan. Currently, the World Bank expects +0.8 and +0.5% GDP growth for 2019 and 2020 respectively. These forecasts have been routinely revised lower.

Of recent events, it worth highlighting that business confidence in December fell to a six-year low and a new consumption tax hike is having the expected negative effects. Additionally, a combination of weaker economic activity among major trading partners and the relative strength of the yen is harming exports.  The odds of a recession in the coming quarters is high.

Germany

Germany is the world’s fourth-largest economy and the largest in the euro region. Over the last six months, soft and hard data has been notably weaker. A recent string of poor data is behind the government’s revision of Germany’s forecasted GDP from 1.8% to 1.0% in late January and similar revisions by the IMF and Ifo Institute.

German GDP fell by 0.2% in the third quarter marking the first decline since 2014. Expectations for the fourth quarter stand at +0.2%. A decline in the fourth quarter (reported 2/14/19) would mark an official recession.

It is worth also adding that the weakness is being felt throughout the euro region. The weakness of European economies has been and continues to catch economic forecasters by surprise. The Citi Eurozone Economic Surprise Index which compares economic forecasts versus actual economic data was negative in January and was negative for most of the last year. On January 31st Italy posted a negative fourth quarter GDP number. The surprising data, follows a negative third quarter, and officially puts Italy in a recession.

United States

Currently formulating economic expectations for the United States is very difficult. Before the government shutdown, there were signs from “soft” economic data points that growth was slowing. “Soft” refers to surveys and opinions about the activity that companies are seeing. These reports tend to be subjective and not always reliable. Hard data like retail sales, employment, and durable goods reports, can take 6-weeks to three months for release from the time the activity occurred. Given the time delays and the fact that some hard data releases have been delayed due to the shutdown, we are forced to depend more than usual on soft data while other economic reports catch up.

Soft data has been running, pardon the pun, soft recently.  The graph below is based on a composite index of 12 data points many of which are soft. As shown below in red, the soft data index appears to have reversed course.

One of the components of the index above is the Leading Economic Index (LEI) which, as shown alongside GDP below, is sending a similar message.

Based on weak global growth trends and the soft domestic data, we have lowered our expectations for economic growth in the first half of 2019. Our confidence is heightened by the fact that the growth benefits of the tax cut stimulus and a significantly larger Federal deficit in 2018 will not have the same incremental impact going forward.

While the government shutdown was unpleasant for the country, the effects will likely not be felt to any large degree outside the beltway. If GDP growth is weaker than expected for the first quarter, rest assured many will use the government shutdown as a scapegoat. The truth is that a weaker GDP report is likely signaling something more concerning.

Markets tend to be forward-looking so it is possible that with the market decline in the fourth quarter, slower economic activity may already be priced in. Looking ahead, the biggest question in our mind is whether the slowdown is temporary or presaging a recession. The jury is still out, but the Chinese economy and the relevance of trade talks on their economy is probably the most important factor to that outcome.

Let’s Be Like Japan

There has been a lot of angst lately over the rise in interest rates and the question of whether the government will be able to continue to fund itself given the massive surge in the fiscal deficit since the beginning of the year.

While “spending like drunken sailors” is not a long-term solution to creating economic stability, unbridled fiscal stimulus does support growth in the short-term. Spending on natural disaster recovery last year (3-major hurricanes and two wildfires) led to a pop in Q2 and Q3 economic growth rates. The two recent hurricanes that slammed into South Carolina and Florida were big enough to sustain a bump in activity into early 2019. However, all that activity is simply “pulling forward” future growth.

But the most recent cause of concern behind the rise in interest rates is that there will be a “funding shortage” of U.S. debt at a time where governmental obligations are surging higher. I agree with Kevin Muir on this point who recently noted:

“Well, let me you in on a little secret. The US will have NO trouble funding itself. That’s not what’s going on.

If the bond market was truly worried about US government’s deficits, they would be monkey-hammering the long-end of the bond market. Yet the US 2-year note yields 2.88% while the 30-year bond is only 55 basis points higher at 3.43%. That’s not a yield curve worried about US fiscal situation.

And let’s face it, if Japan can maintain control of their bond market with their bat-shit-crazy debt-to-GDP level of 236%, the US will be just fine for quite some time.”

That’s not a good thing by the way.

Let’s Be Like Japan

“Bad debt is the root of the crisis. Fiscal stimulus may help economies for a couple of years but once the ‘painkilling’ effect wears off, U.S. and European economies will plunge back into crisis. The crisis won’t be over until the nonperforming assets are off the balance sheets of US and European banks.” – Keiichiro Kobayashi, 2010

While Kobayashi will ultimately be right, what he never envisioned was the extent to which Central Banks globally would be willing to go. As my partner Michael Lebowitz pointed out previously:

“Global central banks’ post-financial crisis monetary policies have collectively been more aggressive than anything witnessed in modern financial history. Over the last ten years, the six largest central banks have printed unprecedented amounts of money to purchase approximately $14 trillion of financial assets as shown below. Before the financial crisis of 2008, the only central bank printing money of any consequence was the Peoples Bank of China (PBoC).”

The belief was that by driving asset prices higher, economic growth would follow. Unfortunately, this has yet to be the case as debt both globally and specifically in the U.S. has exploded.

“QE has forced interest rates downward and lowered interest expenses for all debtors. Simultaneously, it boosted the amount of outstanding debt. The net effect is that the global debt burden has grown on a nominal basis and as a percentage of economic growth since 2008. The debt burden has become even more burdensome.”

Not surprisingly, the massive surge in debt has led to an explosion in the financial markets as cheap debt and leverage fueled a speculative frenzy in virtually every asset class.

The continuing mounting of debt from both the public and private sector, combined with rising health care costs, particularly for aging “baby boomers,” are among the factors behind soaring US debt. While “tax reform,” in a “vacuum”  should boost rates of consumption and, ultimately, economic growth, the economic drag of poor demographics and soaring costs, will offset many of the benefits.

The complexity of the current environment implies years of sub-par economic growth ahead as noted by the Fed last week as their long-term projections, along with the CBO, remain mired at 2%.

The US is not the only country facing such a gloomy outlook for public finances, but the current economic overlay displays compelling similarities with Japan in the 1990s.

Also, while it is believed that “tax reform” will fix the problem of lackluster wage growth, create more jobs, and boost economic prosperity, one should at least question the logic given that more expansive spending, as represented in the chart above by the surge in debt, is having no substantial lasting impact on economic growth. As I have written previously, debt is a retardant to organic economic growth as it diverts dollars from productive investment to debt service.

One only needs to look at Japan for an understanding that QE, low-interest rate policies, and expansion of debt have done little economically. Take a look at the chart below which shows the expansion of the BOJ assets versus the growth of GDP and levels of interest rates.

Notice that since 1998, Japan has not achieved a 2% rate of economic growth. Even with interest rates still near zero, economic growth remains mired below one-percent, providing little evidence to support the idea that inflating asset prices by buying assets leads to stronger economic outcomes.

But yet, the current Administration believes our outcome will be different.

With the current economic recovery already pushing the long end of the economic cycle, the risk is rising that the next economic downturn is closer than not. The danger is that the Federal Reserve is now potentially trapped with an inability to use monetary policy tools to offset the next economic decline when it occurs.

This is the same problem that Japan has wrestled with for the last 25 years. While Japan has entered into an unprecedented stimulus program (on a relative basis twice as large as the U.S. on an economy 1/3 the size) there is no guarantee that such a program will result in the desired effect of pulling the Japanese economy out of its 30-year deflationary cycle. The problems that face Japan are similar to what we are currently witnessing in the U.S.:

  • A decline in savings rates to extremely low levels which depletes productive investments
  • An aging demographic that is top heavy and drawing on social benefits at an advancing rate.
  • A heavily indebted economy with debt/GDP ratios above 100%.
  • A decline in exports due to a weak global economic environment.
  • Slowing domestic economic growth rates.
  • An underemployed younger demographic.
  • An inelastic supply-demand curve
  • Weak industrial production
  • Dependence on productivity increases to offset reduced employment

The lynchpin to Japan, and the U.S., remains demographics and interest rates. As the aging population grows becoming a net drag on “savings,” the dependency on the “social welfare net” will continue to expand. The “pension problem” is only the tip of the iceberg.

If interest rates rise sharply it is effectively “game over” as borrowing costs surge, deficits balloon, housing falls, revenues weaken and consumer demand wanes. It is the worst thing that can happen to an economy that is currently remaining on life support.

Japan, like the U.S., is caught in an on-going “liquidity trap”  where maintaining ultra-low interest rates are the key to sustaining an economic pulse. The unintended consequence of such actions, as we are witnessing in the U.S. currently, is the ongoing battle with deflationary pressures. The lower interest rates go – the less economic return that can be generated. An ultra-low interest rate environment, contrary to mainstream thought, has a negative impact on making productive investments and risk begins to outweigh the potential return.

More importantly, while there are many calling for an end of the “Great Bond Bull Market,” this is unlikely the case for two reasons.

  1. As shown in the chart below, interest rates are relative globally. Rates can’t rise in one country while a majority of global economies are pushing low to negative rates. As has been the case over the last 30-years, so goes Japan, so goes the U.S.
  2. Increases in rates also kill economic growth which drags rates lower. Like Japan, every time rates begin to rise, the economy rolls into a recession. The U.S. will face the same challenges. 

Unfortunately, for the current Administration, the reality is that cutting taxes, tariffs, and sharp increases in debt, is unlikely to change the outcome in the U.S. The reason is simply that monetary interventions, and government spending, don’t create organic, sustainable, economic growth. Simply pulling forward future consumption through monetary policy continues to leave an ever-growing void in the future that must be filled. Eventually, the void will be too great to fill.

But hey, let’s just keep doing the same thing over and over again, which hasn’t worked for anyone as of yet, but we can always hope for a different result. 

What’s the worst that could happen?  

Have Tariffs Worked as Planned? – Part 2

“Peter Cook is the author of the ‘Is That True?’ series of articles, which help explain the many statements and theories circulating in the mainstream financial media often presented as “truths.” The motives and psychology of market participants, which drives the difference between truth and partial-truth, are explored.”

In Part 1, Are Tariffs Working as Planned?, it was demonstrated that the 25% tariff on steel imports in early 2018 produced a 50% increase in the domestic price of steel.  This result is as expected; tariffs are designed to boost the domestic price of the targeted commodity.

We then examined the stock performance of steel producers and steel consumers (auto and RV sectors), between January 11, 2018, the date the Commerce Department issued the report justifying tariffs, and August 3, 2018.  Over that time horizon, the stock prices of the steel consumers we examined were down between 16% and 38%.  While some may question the magnitude of these declines, the direction is plausible for industries experiencing an increase in a primary manufacturing input.

Over the same time horizon, the stock prices of steel producers were down between 6% and 32%, while the S&P 500 and Russell 2000 indices were up 3% and 8%, respectively.  The extremely poor performance of steel stocks on both an absolute and relative basis is anomalous.  Tariffs are designed to boost the income of domestic producers in the targeted industry, which would presumably be reflected in stock prices.

In summary, the stocks of steel consumers AND producers have both nosedived since the tariffs were introduced, which couldn’t have been the intended result of government policy makers.  What could explain the divergence between the expected and actual performance of the stocks of steel producers?

First, let’s review the data for stock, index, currency, and bond prices for the periods January 11 through August 3, which show:

  • Steel stocks are down significantly since the January 11th Commerce Department report, both on an absolute basis and relative to stock market indices, which are up.
  • Steel stocks are down even though they experienced a surge higher during a week in February when word of the upcoming 25% tariff was leaking.
  • Steel companies should be prime beneficiaries of the tariff on U.S. imports because their operations are highly focused on the U.S. market
  • The U.S. dollar and bond yields are up modestly during 2018, but probably not enough to cause large changes in equity and commodity markets

It is impossible to completely untangle and quantify all the influences on stock prices, but the following items potentially explain the dramatic underperformance of steel stocks in the face of a rise in domestic steel prices:

  • The Fed’s interest rate hikes
  • The economy isn’t as strong as believed
  • Dormant corporate buyback programs
  • Tariffs don’t work as intended

Fed Rate Hikes

As explained in The Fed’s Real Target, the Fed manipulates interest rates to influence the behavior of borrowers, not of investors.  When interest rates rise, borrowing costs to finance capital expenditures rise, which discourages capital investment and increases the cost of existing capital investment.  Steel production is capital-intensive, as are the main steel-consuming businesses, which are construction, vehicles, and oil exploration.  Since 2015, the Fed has raised short-term interest rates seven times, for a total of 1.75%.  Fed Chair Powell’s recent comments reveal a determination to continue raising rates to3.00% – 3.50%, in response to a “strong” economy.

So far, the Fed’s actions have had less of an impact on long-term interest rates.  In fact, the yield curve has been flattening, a signal that the Fed’s rate hikes will suppress future GDP growth and inflation, possibly to the point of inducing a recession.  Reinforcing the bond market’s message, stocks of companies that require large capital investments (e.g., industrial and basic materials sectors) have significantly lagged the market indices.  The stocks of steel, auto, and RV stocks are not only lagging market indices; they are down significantly 2018 YTD.

The Economy Isn’t as Strong as Believed

The U.S. Bureau of Economic Analysis recently announced the real growth rate for Q2 2018 GDP was 4.1%, much higher than economic growth over the past decade, which has averaged roughly 2%.  Other economic statistics, such as an extremely low unemployment rate, support the notion of above-average economic growth.  In addition, stock prices are pushing higher, supporting the idea that higher growth is ahead.

However, economists at Morgan Stanley have estimated that supply-chain adjustments (inventory hoarding) in advance of looming tariffs may have boosted GDP growth by roughly 2%.  If so, the U.S. economy is plodding along at the same rate as in previous years.  The automotive sector, a major consumer of steel, is no longer growing, and has plateaued at roughly 17 million units per year.  Rising mortgage rates are taking a bite out of new home sales activity.

Economic growth outside of the U.S. appears to have peaked in Q3 2017, which counters the narrative that global economic growth is in a synchronized upswing, a narrative that has been dominant for almost a year.  The decline in the price of copper, down 16% YTD, supports the thesis of declining global growth.

Finally, as explained in “The Next Recession Is Closer Than You Think,” since 1970 the combination of a 200 basis point rise in short-term interest rates plus a doubling of crude oil prices has always resulted in a recession, with no false signals.  That combination will be present as soon as the Fed hikes rates, which is widely expected in September.

Perhaps the poor performance of cyclical stocks and the flattening of the yield curve are market-based signals that GDP growth will not be as robust as many expect.

Dormant Corporate Buyback Programs    

Most of the largest U.S. companies engage in corporate buyback programs, typically buying a specific number of shares over a specific time-frame.  In almost all cases, company buyback programs are price-insensitive, and probably victims of front-running by algorithmic traders, which pushes the share prices higher when they transact, a process that was explained in Corporate QE.

Meanwhile, steel companies are not buying significant amounts of their own stock, as shown below.

Per regulatory filings, U.S. Steel has not authorized a buyback program and AK Steel bought back a de minimus amount of stock during 2018, while Nucor bought back $29 million, which is small compared to its $20 billion market capitalization.  In contrast, U.S. companies are buying back stock at the highest rate in history during 2018, which is undoubtedly pushing their stocks to higher prices than they would otherwise would be.  The divergence in buyback activity explains some of the underperformance of steel stocks relative to the market indices.

Tariffs Don’t Work As Intended

According to the Law of Supply and Demand, what happens when price rises?  Consumers don’t buy as much at the higher price.  Accordingly, if import tariffs cause the price of domestic steel to rise, the demand for steel is reduced.  This behavior would be aggravated by increases in the cost of financing capital purchases due to Fed rate hikes.

One wrinkle in the steel market is that producers sell to consumers in the spot and contract markets.  In the spot market, prices adjust immediately, so tariff-induced price increases are felt immediately by producers and consumers.  In the contract market, prices are locked in for a fixed quantity over a fixed time.  In its Q2 2018 investor presentation, U.S. Steel reported the breakdown of its sales as shown below.  The chart shows that it will take time for the increase in spot steel prices to flow through to users.

But if the economy is weaker than believed, the race is on.  In coming quarters, can price increases stick and increase the cash flow of steel producers, or will higher prices be negated by a slower economy and declining volumes?  The price of steel stocks points to the latter, not the former.

Conclusions

Import tariffs on steel have produced an expect result; a 50% rise in the price of domestic steel.  The purpose of import tariffs is to improve the profitability of steel production in the United States.  However, the stocks of steel companies are mysteriously producing negative returns during a year in which stock market indices are in positive territory.

Reasons for this anomalous performance include:

  • The Fed’s rate hikes, which harm borrowers in capital-intensive businesses
  • The economy isn’t as strong as believed, particularly in goods-producing industries
  • Dormant corporate buyback programs by steel producers, compared to record-breaking buyback activity by other companies
  • Tariffs don’t work as intended
    • Steel is traded in both spot and contract markets, so revenues lag price changes
    • Large price increases cause a reduction in demand, so there is a conflict between higher revenues and lower economic activity in the steel sector.

The Fed believes the economy is “strong,” warranting a series of interest rate increases.  However, the bond market is reinforcing the message of stocks in the vehicle, homebuilding, and industrial sectors, warning that economic growth and inflation may not be as strong as commonly believed.

Have Tariffs Worked as Planned?

“Peter Cook is the author of the ‘Is That True?’ series of articles, which help explain the many statements and theories circulating in the mainstream financial media often presented as “truths.” The motives and psychology of market participants, which drives the difference between truth and partial-truth, are explored.”

For all the huffing and puffing by government leaders, and the financial media, on the emerging Trade War, the stock market appears uninterested.  On July 31 the White House floated the idea of increasing the tariff rate on $200 billion of Chinese imports, from 10% to 25%.  Commerce Secretary Ross reiterated the strategy on August 2, saying “We have to create a situation where it’s more painful for them to continue their bad practices than it is to reform.”  It is difficult to misinterpret that statement.

The Chinese responded by saying the U.S. leaders should “calm down,” and that pressure tactics will never produce an agreeable response.  Despite all the noise on tariffs, the S&P 500 rose 0.7% during that week.  Intense mudslinging over the ensuing weekend produced the unremarkable result of an unchanged open to trading on Monday, August 7.  The divergence between negative tariff news and positive price reaction is another textbook example of the futility of forecasting short-term stock price movements.

Threats of tariffs are one thing; actual tariffs are another.  In the steel sector, the Commerce Department issued a report on January 11, 2018, demonstrating a violation under Section 232, justifying 25% tariffs on U.S. steel and aluminum imports. The tariffs were clarified on February 14 and imposed on March 8.   These events provide a 7-month window through which to analyze the effect of actual tariffs, instead of threatened tariffs and other negotiating tactics.  Hence, the following analysis on the price of the targeted commodities (steel and aluminum), and the stock prices of steel producers and consumers.

The Wall Street Journal produced the statistics below, showing that the price of steel has risen from $600/ton to $900/ton, or 50%, since early 2018 when the threat of tariffs became a reality.  Aluminum prices have risen 20% over the same time frame. The graph below charts the increase in the price of steel and aluminum. The graph to their right is meant to help contemplate the question, when will price increases in the supply chain begin to affect consumer prices?

Regardless of whether one believes tariffs are good or bad for the overall economy, there should be no disagreement that tariffs are positive for producers in the targeted industry of the country levying the tariff.  In the short-run, before domestic supply can expand, prices should rise to reflect the new imbalance between existing supply and a higher level of demand. The whole point of tariffs is to protect a domestic industry from “unfair” foreign competition, spurring a rise in domestic prices, which has indeed occurred in the steel and aluminum industries.

Stock Market Reaction

Producers

How has the stock market reacted to the expected bonanza for steel and aluminum producers? As shown in the right-hand column below, the three steel companies are highly focused on the U.S. market, while Alcoa (aluminum) derives almost half its sales from the U.S.  So there is no question that the rise in domestic steel and aluminum prices has a direct and major impact on the overall profitability of the companies.

But each stock is down significantly since the close of trading on the day before the Commerce Department report on January 11 (between 6% and 32%, left-hand column).  The table also shows stock performance since February 8, which was the market low in the wake of the implosion of volatility-related ETFs.  The week of February 9-16 produced an enormous rally in steel stocks as word began to leak that the tariffs would indeed be implemented.  However, even measuring from the market low of February 8, three of the stocks (AA), (X), and (AKS) are down, while Nucor (NUE) is up 7%.  For comparison purposes, the performance statistics of SPX and the Russell 2000 Index (R2000) are shown over the same time horizons.  The steel stocks, which have domestic revenue concentration similar to the Russell 2000 index, are trailing that index by a large margin over the entire period.

Summarizing, steel and aluminum stocks are the beneficiaries of tariffs that should support their U.S.-focused businesses.  Yet they have been poor performers, whether measured on an absolute basis or relative to U.S. stock market indices.

Consumers

Next, let’s turn attention to the steel and aluminum consumers.  All other things equal, tariffs should place industrial consumers at a disadvantage, because they may not be able to pass rising costs along to their customers.   As shown below, the performance of the big three automakers and two large RV producers has been poor, on both an absolute basis, and relative to stock market indices.  The RV producers (Winnebago (WGO) and Thor (THO)) have taken the worst hit, presumably because their factories and sales are heavily concentrated in the U.S.  Also notable is that the stocks of these companies didn’t bounce very much during the week of February 9-16, when a spectacular stock market rally coincided with the anticipation and announcement of tariffs for the steel and aluminum industries.   This is a logical result; a sharp rise in input costs is clearly negative for industrial steel and aluminum consumers.

Conclusions

Mainstream economics long ago decided that the broad effects of tariffs are negative, even if they are positive for a specific sector.  In the case of tariffs imposed on the U.S. steel and aluminum markets in early 2018, one would expect that producers would benefit while industrial consumers and likely end users (customers) would be harmed.

However, judging by the price changes to the affected stocks, domestic steel consumers and producers have BOTH been harmed.  That fact suggests that either the stock market is wrong or the economic textbooks are wrong.  In a subsequent article, we will investigate the potential reasons for this anomalous result.

What Can QE Tell Us About QT?

“Peter Cook is the author of the ‘Is That True?’ series of articles, which help explain the many statements and theories circulating in the mainstream financial media often presented as “truths.” The motives and psychology of market participants, which drives the difference between truth and partial-truth, are explored.”

In “The Fed’s Real Target” it was explained that the Fed’s interest rate manipulations are intended to influence the behavior of borrowers, not investors.  Fed Chairman Powell agrees.  In his most recent press conference, Powell reiterated that the Fed Funds rate continues to be the Fed’s primary tool to influence the U.S. economy.  Based on the Fed’s analytical framework, the economy is slowed by a series of interest rates increases because the behavior of borrowers is constrained.  Using similar logic, the economy is stimulated by a series of interest rates declines because borrowers use the reduction in interest expense for other purposes that promote economic growth.

But the Fed also bought a non-trivial amount ($3.6 trillion) of government obligations during the Quantitative Easing (QE) experiment, in the belief that QE would also boost the U.S. economy. Unlike interest rate manipulations, QE is direct manipulation of bond prices and yields and is clearly directed at investors, not borrowers. This key difference between who QE and QT targets are incredibly important and often not fully appreciated by investors.

Since November 2017, the Fed has embarked on Quantitative Tightening (QT), a policy that forces investors to refinance trillions of U.S. government obligations that are maturing from the Fed’s portfolio.

Can the movement of asset prices during the QE period give clues about how asset prices might move during QT?  In this article, we show that the Fed’s QE policy produced the counterintuitive result of higher yields on Treasury bonds, not lower yields as implied by supply/demand analysis.  Using symmetrical logic, the Fed’s QT policy should be expected to reverse the effects of QE, and to produce the counterintuitive result of lower yields, not higher yields implied by supply/demand analysis.

QE was launched in 2008 and ended in late 2014 after three rounds of purchases plus Operation Twist which extended the duration of their holdings  Digging through the archives, the following chart shows that the S&P 500 index (SPX) rose 176% during the periods in which QE was operative (colored lines) while SPX declined 32% during non-QE periods (gray).  Since mid-2015, when the chart was created, SPX has risen from 2100 to 2785, a gain of 31% that offset almost all the 32% loss.  Clearly, QE produced an upward bias to stock prices. While the topic for another article, it is worth pointing out that many other central banks continued buying assets after QE ended via their QE programs and this activity played a role directly and indirectly in supporting SPX.

Moving to the market for U.S. Treasury bonds, QE produced quite a different result than many had expected.  The 10-year Treasury yield rose by 184bp during periods of QE and fell by 293bp during non-QE periods.  Despite massive bond purchases by the Fed, sales by other investors overwhelmed the Fed’s actions.  Since mid-2015, when the chart below was created, 10-year Treasury yields have risen from 2.25% to 2.85%, offsetting some of the decline in yields that occurred during non-QE periods since 2008.

Why might yields have risen during periods of QE, when the Fed was buying trillions of dollars of bonds?  The chart below shows that inflation expectations rose by a total of 274bp during periods of QE and fell by 104bp during non-QE periods.  Markets apparently believed that QE would produce a systematic increase in inflation.

Summarizing the results of stock and bond markets post-2008, during QE periods, the Fed bought $3.6 trillion of government obligations, but bond yields rose.  During non-QE periods, bond yields fell.  Almost nobody expected that a multi-trillion program of buying government bonds would result in declining prices (rising yields) for government bonds.  Yet that’s what happened.  Based on the movement in breakeven yields, investors believed QE would result in systematically higher inflation.  During QE periods SPX rose, and during non-QE periods SPX was basically unchanged.

Viewed from the perspective of a portfolio, QE clearly changed the risk tolerance of investors, who sold U.S. Treasury bonds to the Fed and used the proceeds to buy U.S. stocks and a variety of other risky assets that appreciated sharply (real estate, junk bonds, emerging market stocks and bonds, collectibles, etc).  To use technical language, the risk premium fell for risky assets relative to U.S. Treasury bonds.

Transition from QE to QT

Since November 2017, the Fed has been pursuing a policy of QT, allowing a portion of its portfolio of bonds to mature without reinvesting.  If QT is the opposite of QE (essentially, bond-selling instead of bond-buying), it is logical that asset prices will adjust in the opposite direction than what occurred during QE.  That is, bond yields should fall even though the Fed’s actions require investors to now buy $50 billion more of government obligations each month.  Stock markets should fall because investors will sell risky assets to meet the increased supply of Treasury bonds.   But what is the actual pattern of prices in the QT era?

SPX has risen by approximately 5% since November, but more than 100% of that gain occurred in December and January, possibly in anticipation of corporate tax cuts.  Since January, the trend has been downward and much more volatile.  QT began slowly, at $10 billion per month, but starting in July 2018 it has been ramped up to $50 billion per month in maturing bonds.  QT may already be taking a toll on the stock market.

How about the bond market?  The combination of higher deficits, higher short-term interest rates, and the Fed’s QT program means that investors will need to buy more than $1 trillion in newly-issued Treasury notes in each of the next few years.  A simple supply/demand analysis would suggest that bond yields should rise during a period of QT, just as a simple supply/demand analysis would suggest that bond yields should have declined during QE.

As shown below, bond yields have indeed risen since the beginning of QT, from 2.40% to 2.85%.  But just as with the stock market, most of the move occurred in December and January, as markets began to anticipate the stimulative effect of corporate tax cuts.   Since January, bond yields have gone sideways, defying the predictions of those who believed long-term interest rates would inevitably rise because of the Fed’s rate hikes and increased deficit spending, each of which increases the supply of U.S. Treasury bonds.

Are the bond markets expecting a return of inflation?  The chart of inflation expectations below is remarkable because inflation expectations have remained in a narrow range of 1.5-2.5% for most of the past 15 years.  As a result, relatively small changes can appear to be larger than they really are.  During the entire QE era, inflation expectations were also anchored in the 1.5-2.5% range, although as explained previously, inflation expectations rose during QE periods and fell during non-QE periods.  Since QE ended in late 2014, inflation expectations fell from 1.8% to 1.2% as the price of crude oil crashed from $110 to $26 per barrel.  Inflation expectations then rose to the current 2.1% level. That said, QT seems to have put a lid on rising inflation expectations, which have been stuck at 2.1% for the past six months.

Many, including the Fed, fear that inflation will spike higher.  But the ever-flattening yield curve, which is an excellent leading indicator of recessions, suggests that bond markets are beginning to believe that the next move in inflation is down, not up.  The flat yield curve also supports our analysis in “Does Surging Oil Costs Cause a Recession?” which shows that a combination of rising short-term interest rates and a doubling of crude oil prices preceded each recession since 1970, with no false signals.  Those conditions exist in 2018.

Finally, the prices of industrial metals such as copper are nosediving.  Many will attribute the recent weakness in metals to the threats of a trade war.  But it is also possible that the Fed’s combo-platter of QT (aimed at investors) and rising U.S. interest rates (aimed at borrowers) is a primary culprit.  Regardless whether the trade war or Fed actions are responsible, it is clear that commodities investors don’t like what’s on the menu.

Conclusions

The purpose of this article is to estimate the future direction of asset prices based on the logic that QT will have the opposite effect on asset prices then occurred during QE.

Here’s what we know happened during QE:

  • QE changed the behavior and preferences of investors, which greatly affected relative prices
  • QE produced an expected result of higher stock prices
  • QE produced an increase in inflation expectations, which produced the unexpected result of higher Treasury bond yields

If markets respond to QT symmetrically to how they responded during QE, then:

  • QT will change the behavior and preferences of investors and change relative prices
  • QT will produce lower stock prices
  • QT will reduce expectations for inflation, resulting in lower Treasury bond yields

So far, the QT era has not produced lower stock prices and bond yields.  That said, it is too early to make a definitive statement on QT’s ultimate impact.  The full force of QT ($50 billion per month) has just begun, and there are signs that stocks and bonds are beginning to change direction.  Since November when QT began, SPX has risen.  But since the January peak that occurred in the wake of tax cuts, the trend of SPX is downward and more volatile.  Since November, bond yields have also risen.  But as with SPX, since January a change has occurred; bond yields have stopped rising.

It is possible that the trends in effect since January will persist and possibly intensify throughout the QT era, which would be a surprise to the consensus view that interest rates will inevitably rise due to an increasing supply of Treasury bonds.  Other important data points also suggest that Treasury bond yields may continue to fall; inflation expectations have been static since QT was launched in late 2017, the yield curve continues to flatten to levels not seen since 2007, and industrial commodities are in freefall.

RIA Chart Book: Q2-2018 Most Important Charts

As we wrap up Q2 of 2018, Michael Lebowitz and I present our “chartbook” of the “most important charts” from the last quarter for you to review.

In addition to the graphs, we provided a short excerpt from the article as well as the links to the original articles for further clarification and context if needed. We hope you find them useful, insightful, and importantly we hope they give you a taste of our unique brand of analysis. In most cases, the graphs, data, and commentary we provide are different from that of the business media and Wall Street. Simply put, our analysis provides investors an edge that few are privy to.


There Will Be No Economic Boom

“Wages are failing to keep up with even historically low rates of “reported” inflation. Again, we point out that it is likely that your inflation, if it includes the non-discretionary items listed above, is higher than “reported” inflation and the graph below is actually worse than it appears.”

“But this is nothing new as corporations have failed to ‘share the wealth’ for the last couple of decades.”

Read: There Will Be No Economic Boom – Part 2


Buybacks Run Amok

“Another major pillar of support for equity prices is corporate buybacks. The graph below shows the correlation between buybacks and the S&P 500 since 2000 (note that 2018 is an estimate).”

“Further support for this theory comes from Goldman Sachs who claims that corporations have been the biggest class of buyer of equities since 2010 easily surpassing ETF’s, foreign investors, mutual funds, households and pension funds.”

Read: BTFD or STFR


The Illusion Of Prosperity

“The illusion of economic growth has been fueled by ever increasing levels of debt to support consumption. However, if you back out the level of debt you get a better picture of what is actually happening economically.”

“When credit creation can no longer be sustained the markets must begin to clear the excesses before the cycle can begin again. That clearing process is going to be very substantial. With the economy currently requiring roughly $3.50 of debt to create $1 of economic growth, the reversion to a structurally manageable level of debt would involve a $25 trillion reduction of total credit market debt from current levels.”

Read: The Debtor’s Prism


The Average Not The Rule

“The chart below shows the S&P 500 as compared to annualized returns and the average of market returns since 1900.  Over the last 118 years, the market has NEVER produced a 6% every single year even though the average has been 6.87%. 

However, assuming that markets have a set return each year, as you could expect from a bond, is grossly flawed. While there are many years that far exceeded the average of 6%, there are also many that haven’t. But then again, this is why 6% is the ‘average’ and NOT the ‘rule.'”

Read: The Simple Math Of Forward Returns


Borrowing From The Future

As I discussed in “Sex, Money & Happiness:”

“The ‘gap’ between the ‘standard of living’ and real disposable incomes is more clearly shown below. Beginning in 1990, incomes alone were no longer able to meet the standard of living so consumers turned to debt to fill the ‘gap.’

However, following the ‘financial crisis,’ even the combined levels of income and debt no longer fill the gap. Currently, there is almost a $7000 annual deficit that cannot be filled.”

“In the past, when Americans wanted to expand their consumption beyond the constraint of incomes they turned to credit in order to leverage their consumptive purchasing power. Steadily declining interest rates and lax lending standards put excess credit in the hands of every American. Such is why, during the 80’s and 90’s, as the ease of credit permeated its way through the system, the standard of living seemingly rose in America even while economic growth slowed along with incomes.”

Read: Is Ballooning Debt Really Inflationary


Always Optimistic

“Since the end of 2014, investors are paying twice the rate of earnings growth.”

“No matter how you look at the data, the point remains the same. Investors are currently overpaying today for a stream of future sales and/or earnings which may, or may not, occur in the future. The risk, as always, is disappointment.”

Read: Q1-Earnings Review – Risk To Estimates


Yields Tell The Story

“As shown, when the spreads on bonds begin to blow out, bad things have occurred in the markets and economy.”

“For the Federal Reserve, the next “financial crisis” is already in the works. All it takes now is a significant decline in asset prices to spark a cascade of events that even monetary interventions may be unable to stem.”

Read: The Next Crisis Will Be The Last


Economic Realities

“Unfortunately, as much as we would like to believe that Navarro’s comment is a reality, it simply isn’t the case. The chart below shows the 5-year average of wages, real economic growth, and productivity.”

“Notice that yellow shaded area on the right.  As I wrote previously:

‘Following the financial crisis, the Government and the Federal Reserve decided it was prudent to inject more than $33 Trillion in debt-laden injections into the economy believing such would stimulate an economic resurgence.” 

Read: The Mind Numbing Spin Of Peter Navarro


Leverage

“There are two other problems currently being dismissed to support the ‘bullish bias.’

The first, is that while investors have been chasing returns in the ‘can’t lose’ market, they have also been piling on leverage in order to increase their return. Negative free cash balances are now at their highest levels in market history.”

“Yes, margin debt does increase as asset prices rise. However, just as the ‘leverage’ provides the liquidity to push asset prices higher, the reverse is also true.

The second problem, which will be greatly impacted by the leverage issue, is liquidity of ETF’s themselves. 

When the ‘robot trading algorithms’  begin to reverse, it will not be a slow and methodical process but rather a stampede with little regard to price, valuation or fundamental measures as the exit will become very narrow.”

Read: The Risk Of Algo’s


Simple Method Of Risk Management

“The chart below is $1000 invested in the S&P 500 in 1997 on a capital appreciation basis only. The reddish line is just a ‘buy and hold’ plot while the blue line is a ‘switch to cash’ when the 200-dma is broken. Even with higher trading costs, the benefit of the strategy is readily apparent.”

“To Ben’s point, what happens to many investors is they get ‘whipsawed’ by short-term volatility. While the signal gets them out, they ‘fail’ to buy back when the signal reverses.

‘I just sold out, now I’m supposed to jump back in? What if it crashes again?’

The answers are ‘yes’ and ‘it doesn’t matter.’ That is the just part of the investment strategy. 

But such is incredibly hard to do, which is why the majority of investors fail at investing over time. Adhering to a discipline, any discipline, is hard. Even ‘buy and hold,’ fails when the ‘pain’ exceeds an individuals tolerance for principal loss.”

Read: Selling The 200-Day Moving Average


Debt Bubble

“Rising interest rates are a “tax.” When combined with a stronger dollar, which negatively impacts exporters (exports make up roughly 40% of total corporate profits), the catalysts are in place for a problem to emerge.

The chart below compares total non-financial corporate debt to GDP to the 2-year annual rate of change for the 10-year Treasury. As you can see sharply increasing rates have typically preceded either market or economic events. Of course, it is during those events which loan default rates rise, and leverage is reduced, generally not in the most “market-friendly” way.”

Read: Coming Collision Of Debt & Rates


Not What It Seems

“In the past, when Americans wanted to expand their consumption beyond the constraint of incomes they turned to credit in order to leverage their consumptive purchasing power. Steadily declining interest rates, and lax lending standards, put excess credit in the hands of every American. Such is why, during the 80’s and 90’s, as the ease of credit permeated its way through the system, the standard of living seemingly rose in America even while economic growth slowed along with incomes.”

“As I recently discussed with Shawn Langlois at MarketWatch:

With a deficit between the current standard of living and what incomes, savings and debt increases can support, expectations of sustained rates of stronger economic growth, beyond population growth, becomes problematic.

For investors, that poses huge risks in the market.

While accounting gimmicks, wage suppression, tax cuts and stock buybacks may support prices in the short-term, in the long-term the market is a reflection of the strength of the economy. Since the economy is 70% driven by consumption, consumer indebtedness could become problematic.”

Read: Bull Markets Actually Do Die Of Old Age


Employment Illusion

“Why are so many people struggling to find a job and terminating their search if, as we are repeatedly told, the labor market is so healthy? To explain the juxtaposition of the low jobless claims number and unemployment rate with the low participation rate and weak wage growth, a calculation of the participation rate adjusted unemployment rate is revealing.

When people stop looking for a job, they are still unemployed, but they are not included in the U-3 unemployment calculation. If we include those who quit looking for work in the data, the employment situation is quite different. The graph below compares the U-3 unemployment rate to one that assumes a constant participation rate from 2008 to today. Contrary to the U-3 unemployment rate of 4.1%, this metric implies an adjusted unemployment rate of 9.1%.”

Read: Viewing Employment Without Rose Colored Glasses


Retirement Crisis

“The chart below is the S&P 500 TOTAL return from 1995 to present. I have then projected for using variable rates of market returns with cycling bull and bear markets, out to 2060. I have then run projections of 8%, 7%, 6%, 5% and 4% average rates of return from 1995 out to 2060. (I have made some estimates for slightly lower forward returns due to demographic issues.)”

“Given real-world return assumptions, pension funds SHOULD lower their return estimates to roughly 3-4% in order to potentially meet future obligations and maintain some solvency.

It is the same problem for the average American who plans on getting 6-8% return a year on their 401k plan, so why save money? Particularly when the mainstream media, and financial community, promote these flawed claims to begin with.”

Read: Retirees Face A Pension Crisis Of Their Own


How Long To Get Back To Even

The chart below shows the total real return (dividends included) of $1,000 invested in the S&P 500 with dollar cost averaging (DCA). While the periods of losing and recovering are shorter than the original graph, the point remains the same and vitally crucial to comprehend: there are long periods of time investors spend getting back to even, making it significantly harder to fully achieve their financial goals. (Note the graph is in log format and uses Dr. Robert Shiller’s data)”

“The feedback from Josh, Dan and others expose several very important fallacies about the way many professional money managers view investing.

The most obvious is that investors do NOT have 118 years to invest.”

Read: Myths Of Stocks For The Long-Run


These are some of our favorite charts and we hope you find them useful and insightful. Please send us any comments, suggestions, or your favorite charts to us for consideration.

The Fed’s Real Target

“Peter Cook is the author of the ‘Is That True?’ series of articles, which help explain the many statements and theories circulating in the mainstream financial media often presented as “truths.” The motives and psychology of market participants, which drives the difference between truth and partial-truth, are explored.”

When thinking of the term “blunt instrument,” the image of a sledge hammer comes to mind. The effect of a sledge hammer is a large impact, and an indiscriminate one, which means it can have an effect beyond its intended target.  As Fed Chairman Powell reiterated on Wednesday, the Fed Funds rate is the Fed’s main tool of monetary policy.  The Fed Funds rate is a blunt instrument. When the Fed changes the rate, it may intend to constrain some parts of the U.S. economy, but other parts will inevitably feel an impact.  In addition, changes in the Fed Funds rate produce effects around the globe.

A change in interest rates affects both borrowers and savers.  When rates rise, borrowers pay a higher cost for money while savers receive more income for lending money.  But orthodox economic theory asserts that a rise in rates will constrain the economy while a reduction in rates will stimulate the economy.  So orthodox economic theory (and the Fed) is clearly focused on changing the behavior of borrowers, not lenders.  That’s why you never hear an economist saying that an increase in rates will stimulate savers into greater economic production or that a reduction in rates will constrain savers from spending more.

Because the Fed intends to change the behavior of borrowers, this article is focused identifying the borrowing entities the Fed must be targeting.  So, whose behavior is the Fed targeting?  When interest rates rise, borrowers are affected immediately and/or in the future, if they have at least one of the following four characteristics:

  1. Consistently operate at a loss, using deficit financing
  2. Chose to borrow in the past at low short-term rates instead of higher long-term rates
  3. Must refinance maturing debt at a new, higher interest rate
  4. Operate in capital-intensive industries and must borrow to finance large investments

Operate at a Loss Using Deficit Financing

The U.S. government is the best example of a consistent deficit operator. The Fed’s rate hikes are harming the finances of the U.S. government, because it will issue somewhere near $1 trillion in debt this year.  As its pile of outstanding debt increases, so does its commitments to pay interest.  The rise in interest rates only aggravates that problem.

However, if the Fed is correct that the economy is growing strongly, then federal tax receipts will increase, which may partially or fully offset the increase in interest expense.  As Powell said repeatedly during the last FOMC press conference, there is high uncertainty around any prediction, simply because there are very few times in history when large budget deficits and large changes in tax policy coincided with persistently rising interest rates and a looming trade war.  Regardless of the net effect of interest rates and GDP growth on the U.S. budget, orthodox economic theory assumes that the Fed can monetize U.S. federal debt (which it did during QE),  meaning that  a rise in interest rates won’t have much impact on the government’s desire to borrow.  The open question is whether investors will satisfy the government’s desire to borrow, and if so, at what rate of interest, which cannot be known in advance.

Moving from government to corporate finance, the Fed’s policy targets the 34% of the Russell 2000 index of small public companies that does not operate at a profit.  The percentage ranged between 28% and 36% in recent years since peaking at 44% in 2009.  Perhaps more surprising is the pervasive lack of profitability during one of the longest business expansions in U.S. history. The recent corporate tax cut is useless for these companies, because if they don’t have profits, their income tax rate is already 0%.  Some believe the Fed’s zero-interest rate policy (ZIRP) is a major reason why many unprofitable companies are still in existence.  Whether an unprofitable company is publicly or privately owned, operating losses must be funded by either issuing debt or equity.  If the cost of debt is increasing, it is a clear negative for companies that must borrow to fund their operating losses.

Chose to Borrow at Low Short-Term Rates 

The Fed is targeting companies that chose to borrow at short-term interest rates, even if it is difficult to identify exactly which companies they are.  However, it is not difficult to identify the motivation.  Short-term interest rates were pressed to the floor by the Fed’s 8-year experiment with ZIRP.  In addition, short-term rates have been persistently lower than long-term rates by 2-3% for most of the past decade.  At a minimum, it has been a tempting period to borrow at short-term interest rates and save on interest expense.

Investors oblige that temptation, by investing in mutual funds that lend to companies in the leveraged loan market.  Leveraged loans have a floating-rate coupon that adjusts to changes in short-term interest rates.  The market for leveraged loans has doubled since 2012, as shown below, and is nearing the size of the U.S. junk bond market, as it last did in 2007 and 2008.

From the investor’s perspective, leveraged loans and their floating rate coupons are a hedge against the risk of rising interest rates.  That hedge seems sound, but if the borrower’s business model is based on borrowing at low interest rates, an investor in leveraged loans during a period of rising rates is simply exchanging interest rate risk for credit risk.   Given the rapid growth in leveraged loans, and Wall Street’s appetite for generating fees from underwriting securities that aren’t what they appear to be, it is doubtful that investors understand that exchange.

Must Refinance Maturing Debt at Higher Interest Rates 

By hiking rates, the Fed is targeting entities that have issued debt in the past at lower interest rates than exist today or will exist in the future.  The U.S. government, as the largest issuer of outstanding debt, will face this problem as its bonds mature.  Beyond the government, speculative-grade companies that borrow in the junk bond market are also exposed to this risk because they typically borrow at a fixed-rate for 3-10 years.  As their bonds mature, they must refinance the bonds at the prevailing interest rate, which will probably be higher than it was in the past.  The chart below shows how many junk bonds (blue bars) will mature in coming years.

In aggregate, companies may not have too much trouble refinancing their maturing junk bonds in 2018.  But the amount of maturing junk bonds will increase rapidly in future years, which coincides with mushrooming U.S. government borrowing.  Leveraged loan maturities (green bars) will also accelerate during the same period. 

Operate in Capital-Intensive Industries and Must Borrow to Finance Large Investments

A final group of targets of the Fed’s policy to raise interest rates is any borrower that finances large capital investments.  An obvious target is the real estate sector, which accounts for 5% of GDP, plus asset values of $25 trillion for residences and another $12 trillion for commercial property.  Individuals and real estate developers are both highly-leveraged because they borrow 70-80%, or even more, of the money to purchase or develop residences and commercial properties.  For highly-leveraged borrowers, small changes in interest rates make a big difference in economic reality.

The good news is that 90-95% of mortgages used to purchase primary residences are fixed-rate loans in recent years, as shown below.  In contrast, during the housing boom, creative financing was used to purchase almost half of all residences, which is another way of saying that people who couldn’t afford a home were able to buy one.  So it doesn’t appear that a rise in interest rates will directly impair many existing homeowner’s ability to pay their mortgage.

But the bad news is that rising rates will increase the cost of ownership for homeowners and developers in future purchases, which should reduce real estate activity in coming years.  The effect on real estate prices will depend on local supply/demand conditions, and whether the Fed is correct that the risk of an outbreak of inflation is nigh.

Other capital-intensive sectors include the auto, energy, transportation, and communications industries.  Auto companies must continuously invest in machines that make autos, and individuals borrow money to purchase autos.  So higher rates constrain both the producer and the consumer in the auto market.  Exploration for oil requires large investments in capital goods to extract it and transport it to the places where it is refined and consumed.  As detailed in a previous article, since 1970, during periods in which the price of oil doubled and the Fed Funds rate rose by more than 2%, a recession has followed 100% of the time, and with no false signals (LINK).

The transportation industry requires the purchase and maintenance of planes, trains, and trucks.  Communications companies must continue to invest in infrastructure to keep up with the pace of change, which only seems to increase.  In each of these sectors, the Fed is raising rates and targeting a lower level of activity, which means a lower level of GDP.  The broad industrial sector, which produces components for the above industries, is the sector most highly correlated with the direction of the S&P 500 index.  As analyzed here (LINK), the industrials sector has been underperforming for more than six months.

Conclusion

Manipulating the Fed Funds rate is an attempt to manipulate the behavior of borrowers, not lenders.  The Fed states that the U.S. economy is very strong and appears to be fearful that it will grow even stronger.  In response, the Fed is increasing the Fed Funds rate to increase the cost of borrowing.  Solvent, profitable entities will not be financially imperiled by increases in the Fed Funds rate.  But borrowers with any of the following characteristics will be challenged.  Borrowers with more than one of the following characteristics will be particularly challenged.

Operating at a Loss/Deficit:  The largest borrower, the U.S. government, will probably not change its borrowing habits because in an emergency, the Fed could step in and buy Treasury bonds, just as it did during the QE era. However, companies that operate at a loss, which comprise 1/3 of the Russell 2000 index, will not be so lucky.  The costs for borrowing to finance their deficits will rise.

Chose To Borrow at Short Term Rates:  Speculative-grade borrowers in the leveraged loan market are exposed to a rise in rates, they issued debt in floating-rate coupons, which are rising.  By definition, speculative-grade companies are highly leveraged, meaning that a rise in costs will threaten their finances.  Investors who flooded into the leveraged loan market will find that they hedged their interest rate risk but increased their credit risk.

Must Refinance Maturing Debt at Higher Rates:  Entities that issued debt in the past and must replace maturing debt with new debt will probably have to do so at higher interest rates.  The U.S. government faces this problem, but the Fed will probably act to minimize it.  Junk bond issuers are particularly vulnerable to rising rates because interest expense is a large expenditure for highly-leveraged companies, and junk bond maturities will increase in coming years.

Operate in Capital-Intensive Industries:  Activity in capital-intensive industries such as the auto, energy, transportation, communications, and industrial sectors will be negatively affected by an increase in the cost of financing.  In the auto industry, customers will also be facing higher interest rates on car loans.

Fortunately, homeowners have largely used fixed-rate mortgages to purchase their homes over the past decade, so their ability to pay the mortgage will not be directly threatened by a rise in the Fed Funds rate.  However, the Fed’s campaign will slow down future activity in the real estate sector because it will increase the cost of real estate purchase and development, which are highly-leveraged activities.

The Fed is swinging a blunt instrument, and if history is any guide, it will keep swinging until it succeeds in getting what it wants, which is a lower level of economic activity from the borrowers it targets.

The Link Between Public and Private Equity

“Peter Cook is the author of the ‘Is That True?’ series of articles, which help explain the many statements and theories circulating in the mainstream financial media often presented as “truths.” The motives and psychology of market participants, which drives the difference between truth and partial-truth, are explored.”

Each year, private equity powerhouse Bain & Company produces a comprehensive review of the private investments sector. Private investments are thriving because they generate returns that beat public stock market investments, which they have done over multiple time horizons in the past.

Institutional investors have noticed.  Private investment funds raised $700 billion in each of the past two years.  Per McKinsey, the assets of the private investment industry have hurtled above $5 trillion.   But the industry also has a problem; it is pulling in more capital than it can invest.  As of December 2017, almost 1/3 of the money that has been committed ($1.7 trillion) is sitting idle.  The largest single category of private investing is buyout ($600 billion), which focuses on buying companies, some of which are publicly-traded.

What could explain record inflows into an asset class that already is having trouble investing money quickly enough? Private equity investments can only continue to beat public equity investments if some combination of the following variables is present:

  1. Initial valuation is low enough
  2. After an investment or buyout, operations can be made more efficient/profitable
  3. Leverage is employed to magnify the gains from improved efficiency/profitability
  4. Exit valuation is high enough

Private equity firms can only have a direct impact on the second variable, while the first and fourth variables are set by markets (although, as will be shown, private equity bidding helps set market valuations).  The third variable is a function of the lending environment.

Looking at the first variable, valuations for deals done in late 2017 were at an all-time high, and 25% higher than in 2010-2013, as shown below.

The Bain study included a screening tool, attempting to predict how the wall of idle buyout cash might be invested, given today’s high valuations.

“To gauge the potential for public-to-private activity in the year ahead, we looked at the universe of U.S. public companies with enterprise value up to $50 billion (a level beyond which a take-private transaction becomes impractical). We identified close to 800 companies trading at multiples of nine times EBITDA or below, making them relatively attractive targets. Screening them further based on potential for revenue and margin expansion, we ended up with 72 US public companies that seem ripe for conversion. For large GPs eager to put big sums of capital to work, the public markets are likely to offer a fertile field in 2018.”

Summarizing, private equity buyout firms, which have plenty of dry powder and the motivation to use it (fees), are effectively setting a floor valuation for dozens of large U.S. public companies.  We have previously discussed how traditional central bank QE and corporate QE (buybacks), plus the high-frequency traders that front-run them, have boosted stock market valuations.  Private equity investors, lacking good investments in their traditional space, are yet another eager buyer waiting in the wings, although in contrast to the other types of buyers, there appears to be some constraint on the valuations they pay.   The main point is that equity prices do not operate in a vacuum.  Money can be created out of thin air by central banks, borrowed from the banking system, easily converted from one currency to another, or moved from one asset class to another.

High valuations can also be explained, at least partly, by the availability of plentiful leverage.  Although still below the high set in 2007, leverage multiples have been bumping up against a 6x limit that is thought to attract the scrutiny of banking regulators, as shown below.  If leverage is limited while valuations are rising, then more equity must be injected to get the deals done.  But a higher equity component in the capital structure reduces the IRRs that can be achieved on the equity.

The cost of leverage is yet another factor in successful private equity investing.  One big difference between 2007 and recent times is the level of interest rates.  A leveraged private equity deal can be financed at short-term interest rates or long-term interest rates.  Interest rates are much lower today for either type of borrowing, as shown below.  But if the Fed is to be believed, the direction of interest rates is higher in coming years, which would reduce the IRRs of private equity deals in the future, all other things equal.

Summary

There is a surplus of money aimed at the private investments sector, as evidenced by the fact that $1.7 trillion is now committed but not invested, and that number has been growing each year. Of the $1.7 trillion of dry powder, $600 billion is aimed at the buyout sector, which can only be successful with a combination of buying at a low valuation, financing buyout deals with cheap and plentiful leverage, wringing out operational efficiency gains, and selling at a valuation close to what it bought at.

Yet today, valuations are high, interest rates are rising, and leverage ratios are already at a regulatory limit.  In addition, the percentage of equity required to get deals done is rising, which lowers the IRRs that can be achieved in future deals.  Even with those headwinds, the Bain screen shows that dozens of large U.S. public companies could be bought out, which places a floor those companies’ stock prices.  Investors in private equity buyout funds appear to be placing great faith in the ability to create operational efficiencies and/or even higher valuations in the future. Come to think of it, so do investors in the U.S. stock market.

The R2K Conundrum

“Peter Cook is the author of the ‘Is That True?’ series of articles, which help explain the many statements and theories circulating in the mainstream financial media often presented as “truths.” The motives and psychology of market participants, which drives the difference between truth and partial-truth, are explored.”

The persistent rise in interest rates has become a dominant topic of the financial media. It is now common to read articles on how a rise in the 10-year Treasury bond rate to a specific level will produce some type of sea-change in perception and/or reality. Some of those points are already in the rear-view mirror (2.65%), while another was crossed this week (3.05%), and still others lie ahead (3.22%). Some commentators eschew a specific interest rate and instead specify a range, such as 3.50%-3.75%.

The focus on interest rates is understandable. Rising rates are, by definition, a negative influence on bond prices.  With tens of trillions of dollars of bonds outstanding, a rise in interest rates of, say, 1%, produces market losses of hundreds of billions of dollars. If the Fed’s beloved “wealth effect” ever existed, it is now a movie that is running in reverse, perhaps more quickly than it ever ran in forward.

In addition to negatively influencing bond prices, rising rates are perceived to be a negative influence on most other assets, such as real estate, commodities, or private businesses. Of course, this is also true of stock valuations.  Ever since the peak in interest rates in the early 1980s, falling interest rates have been used as a primary justification for rising stock valuations.

Oddly, investors of the Russell 2000 index (R2K), comprised of small-cap companies, don’t seem to care about the connection between rising interest rates and lower stock prices. Defying the predictions of many, R2K made a new all-time high this week while bond yields rose to 7-year highs. This combination is particularly at odds with financial theory because R2K companies have a greater exposure to rising rates than larger companies.  For example, the maturity of the debt of R2K companies matures earlier and carries a higher interest rate than large companies in the S&P500 index (SPX).

Looking at other influences on stock prices, R2K historically tends to rise when the dollar is strong, but it also tends to be weak when the price of oil is rising. So recent changes in the dollar and oil largely negate each other and don’t explain the R2K’s strength.

Diving further into relative valuations, the Wall Street Journal publishes valuations on a weekly basis, as shown in the table below.

The price/earnings ratio (PE) based on the past year’s earnings is far higher for R2K (88.75) than SPX (24.28) and even the NASDAQ 100 index (24.99), an index dominated by the largest U.S. growth (technology) companies, which should presumably be valued more highly than smaller companies. Looking forward, after waving the magic wand which uses operating earnings instead of GAAP earnings, R2K (26.15) is still valued more highly than the SPX (17.05) and NASDAQ (20.25). It is important to note that the P/E calculation for the R2K throws out the earnings of companies losing money, while SPX includes them. Ergo, the true P/E of R2K is larger than it appears. The following quote was from an article written in 2016 that analyzed R2K valuations:

“As a point of comparison, the widely reported P/E ratio of 46 for the R2K appears to be much lower than our value (237x). Unlike, the market benchmark S&P 500, the reported Russell P/E ratio excludes companies with negative earnings. Our analysis appropriately includes both positive and negative earnings.” – Banks in Drag : The Russell 2000 Exposed 

Historically, the R2K is trading near its all-time high in valuation, as shown below by the red line. Since 2003, the R2K traded at a higher valuation only a few times; during the earnings crash and recession of 2009, briefly during 2015, and again throughout 2017. Although Yardeni.com calculates a slightly different P/E for the R2K (24.1) than the WSJ, it is still higher than both the SPX and NASDAQ, and as noted above likely much higher on an apples-to-apples basis.

R2K companies are more exposed to the U.S. economy than larger companies, because larger companies derive a greater percentage of revenues and profits from overseas.  So one explanation for the higher valuation of R2K companies is that U.S. economic growth will be stronger than global growth.  But it is also true that the Fed is well into a tightening cycle that is designed to restrain growth and inflation, while Europe and Japan still have the monetary petal pushed to the metal, including negative interest rates.  As previously explained HERE, the combination of rising interest rates and energy prices has preceded every U.S. recession of the past 45 years, and that combination is present yet again in 2018.

In conclusion, interest rates are rising, but they have not produced the expected effect on stock prices. R2K companies are trading at an all-time high in price as bond yields are breaking to multi-year highs. R2K companies are trading at a high PE multiple relative to larger, more stable companies that have less exposure to rising interest rates. R2K companies also are trading at a high PE multiple relative to historical norms. Perhaps all of these conditions will continue into the future, but that seems like a low-probability bet, which is a major source of risk for small-cap U.S. stocks.

Cook: Clue From the Industrial Sector

“Peter Cook is the author of the ‘Is That True?’ series of articles, which help explain the many statements and theories circulating in the mainstream financial media often presented as “truths.” The motives and psychology of market participants, which drives the difference between truth and partial-truth, are explored.”

The stock market is a market of stocks, or at least it was prior to the ascendance of indexing.  The idea is that certain stocks, or sectors, act as bellwethers for the overall stock market is well-known.

The S&P 500 index (SPX) is composed of eleven economic sectors, among which are technology, utilities, energy, health care, financials, and industrials.  All eleven sectors have a positive correlation with SPX, meaning that they generally go up or down together with the overall market.   At one end of the correlation scale, the utilities sector has the lowest correlation to SPX, at .26 over the past 30 years (on a scale between 0 and 1).  This means that only 26% of the price of the utility index can be explained by the price of the SPX. One explanation for the low correlation is that utilities are regulated entities with high dividends, so the stocks behave more like bonds than stocks.  Energy stocks also have a relatively low correlation of .37, possibly because extremely high energy prices, which are good for energy companies, are bad for the economy and hence the broad stock market.

The industrial sector has the highest correlation with the SPX over the past 30 years, at .86.  Industrial stocks are ones such as Boeing, GE, 3M, and Caterpillar, which produce large capital goods that are used in the transportation, mining, and manufacturing sectors of the economy.  One explanation for the high correlation between the industrial sector and SPX is that if business managers are confident enough to invest capital on large purchases, they must see a relatively bright economic future.  In contrast, if the outlook is uncertain or poor, business managers tend to suspend or pull back on capital expenditures.

Because of the high correlation between the industrial sector and SPX, it is important for investors to examine nuances within the industrial sector for clues about the economy and the stock market.  XLI is a popular industrial sector ETF, which contains a mixture of capital goods and transportation stocks.  The top 10 holdings comprise 45% of the portfolio, with Boeing as the largest holding, at 8%.  XLI also has significant holdings of transportation stocks such as FedEx and Union Pacific.

The chart of XLI’s performance relative to SPX (which we will name XLI/SPX) is shown below.  XLI has performed similarly to, but not identical to, SPX, as suggested by the high correlation between industrial stocks and SPX.  Over the past five years, SPX has risen 62%.  Over that same time span, XLI has outperformed SPX by an additional 16%, as seen where the blue line ends on the right margin.  Over the past five years, there are several interesting points when XLI/SPX peaked, troughed, or moved sharply.   Those points are marked with ovals.

From mid-2013 to mid-2014, industrial stocks were booming along with the increased production of US shale oil, which required machinery to extract from the fields, and rail/truck to transport to storage and pipeline hubs.  However, the peak in XLI/SPX in June 2014 foreshadowed the eventual transition from boom to bust.  As oil fell from $110 in late 2014 to $26 per barrel in early 2016, industrial stocks performed relatively poorly.

In February 2016, the world’s top central bankers met in Shanghai to discuss how the drastic change in the price of oil was inflicting instability on global economies and financial markets.  Their response was the so-called Shanghai Accord.  Among other policy responses, China agreed to give a booster shot to its spectacular (for better and worse) credit creation machine.  Industrial stocks got the memo that China would build more infrastructure (and ghost cities), so XLI/SPX spurted 6% in a short period of time.

The next surge in XLI/SPX occurred in November 2016, when XLI outperformed SPX by 9%. The reason was the surprise election of Donald Trump, who had proposed trillion-dollar infrastructure proposals during his campaign.  More broadly, a Republican sweep of the US government appears to have been seen as friendly to businesses and the military budget.

The final surge in XLI/SPX occurred in late 2018 as expectations rose that a tax cut/reform bill would pass.  XLI increased 6% relative to SPX as a result.  Traditional Keynesian economic theory deems deficit spending to be a booster shot to GDP, which should increase spending of all forms.  In addition, the bill mandated that capital expenditures could be expensed in their entirety in the first year.   Normal tax accounting would require the expenditures written off over 3 or 5 years, so the new mandate effectively lowers the after-tax cost of companies who buy long-lived assets such as machines and vehicles.

Most recently, however, XLI/SPX fell 6%, unwinding the spike that occurred in late 2017.  Why would that occur?  To help answer that question, we compare the XLI/SPX price chart to underlying reality.  In this case, the most relevant economic data for industrial stocks is New Orders for Capital Goods Excluding Aircraft, as reported by the Census Bureau.

Looking at the green arrows, we can see that relative performance of XLI leads changes in orders for capital goods.  For example, the 2014 peak in XLI/SPX occurred prior to the peak in new orders.  The trough in XLI/SPX occurred in Q3 2015, which was prior to the trough in orders in early 2016.  The surge in XLI/SPX in November 2016 occurred prior to the mid-2017 spike in new orders.  In summary, in mid-2014, early 2016, and again in late 2016, the stock market anticipated correctly a change in the underlying economic data.  That is, a change in XLI/SPX preceded either a change in trend or a change in the slope of the trend for capital goods orders.

However, the late-2017 spike in XLI/SPX has so far not been followed by a spike in new orders, as indicated by the red arrow.  It is too soon to draw a definitive conclusion, but the drop in XLI/SPX over the past few weeks could signify that investors are giving up on a new surge in new orders for capital goods.  It is also possible that the decline in XLI/SPX is the beginning of a sustained period of underperformance.  If that occurred, XLI/SPX would confirm the message of a flattening yield curve, increasing the probability of a recession in 2018-19, as discussed in detail in The Next Recession Is Closer Than You Think

Conclusions

  • The industrial sector, as represented by the XLI ETF, is the most highly correlated sector with SPX (.86 over the past 30 years). It appears that whatever is good/bad for the industrial sector is closely aligned with what is good/bad for SPX, which itself is closely aligned with what is good/bad for the economy.
  • The XLI/SPX ratio measures the performance of industrial stocks relative the S&P 500 index. Over the past five years, changes in XLI/SPX have been a leading indicator, meaning it foreshadowed changes in trends for new orders in the capital goods industry.
  • The most recent spike in XLI/SPX occurred in late 2017 as the tax cut/reform bill was passed, apparently in anticipation that tax changes would spur a capital spending boom.
  • However, new orders for capital goods have not boomed; they have remained flat since Q3 2017. The recent decline in XLI/SPX could be a signal that the boom isn’t going to happen.
  • Persistent weakness in XLI/SPX, if it continues, would confirm the message of the flattening yield curve, which is strongly associated with economic weakness, increasing the probability of a recession. A recession in 2018-19 would clearly not be expected by the Fed, economists, and politicians, who are forecasting real GDP growth of 2-3%.

The Next Recession Is Closer Than You Think

“Peter Cook is the author of the ‘Is That True?’ series of articles, which help explain the many statements and theories circulating in the mainstream financial media often presented as “truths.” The motives and psychology of market participants, which drives the difference between truth and partial-truth, are explored.”

If a Hall Of Fame existed for financial beliefs, “market-timing is impossible” would rank right up there with “diversification is the only free lunch in finance.”  These statements have been validated by a large volume of peer-reviewed academic studies, so it is widely believed that there is no need to question their legitimacy.  Although the declining value of diversification was addressed in Diversification Can’t Cure Overvaluation Disease, this article concerns the issue of market-timing for investment portfolios.

First, almost all investors are likely to agree that market-timing, as defined over short-term intervals and based on observed historical patterns, is impossible.  In reality, financial markets are enormously complex systems in which a multitude of investors buy and sell in different magnitudes for different reasons on different days.  On top of that, investors may respond (or be forced to respond) differently to a specific stimulus over time.  While some investors may be able to make excess profits based on known anomalies (e.g., seasonality, small capitalization, valuation, momentum) over long periods of time, even these anomalies are unreliable over shorter periods of time.  If some investors can create excess short-term trading profits, they probably do so because of structural advantages (e.g., informational advantages of market-making, or detecting and front-running corporate buyback programs).  If anyone can create short-term excess profits without those advantages, these precious few certainly don’t and won’t advertise how they achieve their success, which means the rest of us might as well continue to assume it is impossible.

In contrast, the study of longer-term business cycles is valuable for the simple reason that business cycles drive capital markets cycles.  Business cycles run for periods of years, not days, weeks, or months.  So business cycle analysis is different from the common definition of market-timing because it is concerned with a much longer time horizon.  It is difficult for anyone other than politicians to deny the existence of a business cycle, which includes both an expansion and a recession phase because they are a fact of economic life.  A recent Goldman Sachs research piece not only acknowledges the existence of cycles but divides them into four phases and produces recommended asset allocations for each phase, as shown below.

Goldman’s investment recommendation for 2018 is based on the belief that 2018 lies within Phase 3, in which the economy is operating above capacity and growing.   More broadly, Goldman’s chart and table show that identifying the Phases is a crucial determinant of investment success.  For example, if 2018 truly lies within Phase 4, cash and bonds would outperform commodities and equities.  The Fed appears to agree with Goldman’s analysis of Phase 3, based on its simultaneous campaigns to lift the Fed Funds rate and to reduce the size of its bond holdings that were acquired during its QE experiment.

In another admission that business cycles exist, Bank of America/Merrill Lynch (BAML) produces a monthly Fund Manager Survey, in which it asks the largest institutional investment managers a simple question; where are we in the business cycle?  The results from the past decade are shown below.

Beginning with the most recent results, a majority of institutional investors currently believe the global economy is “late-cycle” (gold line), which is an analog for Goldman’s Phase 3.  In fact, this belief has been in existence since early 2016, and the belief has increased in popularity over the last six months or so. For most of the period from 2010-2016, a majority of investors believed “mid-cycle” (blue line) was the best description for the state of the global economy, which is an analog for Goldman’s Phase 2.  In 2009, investors didn’t believe the economy was either in mid-cycle or late-cycle, a fact that will be addressed later in this article.   In 2008, 70% of investors believed the global economy was in late-cycle, and relatively few believed the global economy was mid-cycle, which are similar to the current percentages.

Summarizing the results of the chart above, the investors polled by BAML have thus far been largely correct in their assessment of the state of the global economy.  They correctly identified the economy was late-cycle on the eve of the recession of 2008-09, correctly identified an upswing in the business cycle in early 2010.  Whether they are correct that 2016-2018 is late-cycle (Phase 3) is plausible but remains to be seen.

The BAML survey extends further back than 2008, so we can get a better idea of investors’ beliefs leading to the recession of 2008-09, as shown below.  During these years, investors were given two other choices to describe the economy; early-cycle or recession.  A majority of investors believed the economy was late-cycle beginning in 2005, with a peak in that belief occurring in late 2007 (thin black line), which coincided with a continuous decline in the percentage believing the economy was mid-cycle.  During the period 2005-2007, almost no investors believed that the economy was in either in its early-cycle or recession.

By late 2008, investors believed that a late-cycle economy was giving way to a period of recession, as shown by the decline in the black line and ascendance of the red line.  By late 2009, a majority of investors began to describe the economy as early-cycle, as indicated by the ascendant green line.

Summarizing, investors were largely correct in describing the state of the global economy in the years leading up to the recession.  They began to believe the economy had moved into late-cycle by 2005, a couple of years before the recession struck in December 2007.  By late 2008, they began to understand the economy was in recession, and by mid-2009, they understood the economy was early-cycle, which occurs after recessions.

Furthermore, investors seem to firmly grasp the sequence of the phases of the business cycle, as evidenced by the sequential peaks in the black, red, green, and blue lines during the period of 2007-2012.  That is, it makes sense that a peak in late-cycle would be followed by a recession, which would be followed by early-cycle and then mid-cycle.

Investment Implications for 2018

If Goldman is correct that the economy is in Phase 3, and the BAML investor survey is correct that the global economy has been in late-cycle since 2016, then the next stage of the business cycle will be a recession (Phase 4). However, the timing of a potential recession is uncertain.   What isn’t uncertain and of utmost importance to investors is that the performance of asset classes is radically different in Phase 3 than in Phase 4.  It is also not uncertain that economists will be blindsided by any impending recession, just as has occurred before all of the eleven post-WWII recessions.

With the preceding knowledge, an investor should probably be reducing exposure to equities, precisely at a time when persuasive narratives exist to keep an equity investor in the game (e.g., great earnings reports, globally synchronized growth, fiscal stimulus, etc.).  That is not easy to do.

Can we get more specific on the timing?  Interestingly, a majority of the BAML investor survey voted for late-cycle beginning in late 2005, or a couple of years ahead of the recession that began in late 2007.  This time around, voting for late-cycle became a majority in early 2016, which is about two years ago.  So, in each of these two periods, it isn’t a surprise to investors that the economic expansion is long in the tooth, or that a recession will be coming next.  But it is unlikely that recessions will always follow precisely two years after investors declare a beginning to late-cycle.

The question of timing can also be addressed by the fact that both periods (2005-2007 and 2016-2018) share a common fundamental characteristic; in both periods the Fed persistently raised interest rates while the price of crude oil more than doubled.   Every single recession since 1970 has been preceded by a sharp rise in the cost of money and the cost of energy, as explained here (LINK).  It appears that a rise in oil is perceived as inflationary by the Fed, which then raises rates to counteract inflation.  But business owners and consumers, operating in the real world, see the rising costs of energy and interest on debt as costs they must offset by cutting other areas, whether that be in business expenses such as headcount or advertising, or discretionary consumption for consumers. That process sows the seeds of recession.

The main question a long-only investor must answer in 2018 is how long Phase 3 (late-cycle) will persist.  If an investor assumes it will persist for several more years, then a large allocation to equity and commodities should provide superior performance.  If the end of Phase 3 is coming soon, those allocations will likely perform relatively poorly.  The following argue for a sooner end to Phase 3:

  • The BAML investor survey has described the economy as late-cycle for two years
  • Crude oil has almost tripled over the past two years
  • The Fed has been raising the Fed Funds rate for three years, and is planning to continue down that path
  • The Fed has further tightened liquidity by reducing their balance sheet which in turn decreases the money supply

On the other hand, it is possible that the economy will overcome sharp increases in short-term interest rates and oil prices, delaying the transition from Phase 3 to Phase 4, and extending the stock market advance.  But given the historical record of recessions since 1970 and the investor survey results from 2005-2008, that is a low-probability bet.

Another potential outcome is possible for investors who can implement hedging and/or short sales to their investment strategies.  During both Phase 3 and 4, commodities outperform equities by ~15% per annum.  If Goldman is correct that we are in Phase 3 on the way to Phase 4, AND if historical performance patterns hold, then a long commodities/short equities investment strategy might be rewarding.  In that case, correctly identifying whether the economy is in Phase 3 or 4 is far more important than precisely timing the transition from Phase 3 to Phase 4.

Conclusions

  • Business cycles exist, and the progression through phases of the business cycle is recognized by institutional investors
  • Business cycles drive financial market cycles, as demonstrated by the radically different pattern of asset class performance during the different phases of the business cycle
  • Economists’ views on the potential for a recession will probably be inadequate because they have been unable to predict any Post-WWII recession, so it is unlikely they will do so now
  • A majority of BAML’s institutional investors have correctly described the state of the economy over the past 15 years, although they also were late in recognizing the recession of 2008-09
  • For the past two years, BAML’s investors have described the global economy as late-cycle, reaching a recent peak of 70+%. The length and magnitude of late-cycle consensus also occurred from 2005-08, which increases the probability of a transition to recession in 2018 or 2019
  • The combination of sharply rising costs for money and energy, which occurred before each recession since 1970, increases the probability of a transition to recession in 2018 or 2019
  • The increasing probability of recession should be reflected in the structure of investment portfolios, either by reducing equity exposure or by implementing a long commodity/short equity strategy.

Does Surging Oil Prices Cause Recession? Depends On The Fed

“Peter Cook is the author of the ‘Is That True?’ series of articles, which help explain the many statements and theories circulating in the mainstream financial media often presented as “truths.” The motives and psychology of market participants, which drives the difference between truth and partial-truth, are explored.”

It is widely known that a rise in interest rates, engineered by the Federal Reserve Bank (Fed), has preceded recessions over the past several decades.  However, knowing that a sharp rise in rates preceded recessions is one thing.  Knowing that a sharp rise in rates caused recessions is another thing.  To establish causation, each period of rising Fed Funds rates would have to precede each recession.  But that’s not what happened over the past five decades.  Conventional wisdom may capture popular thought at a moment in time but isn’t always true, and it shouldn’t drive investment decisions.

The Fed Funds rate, which the Fed controls, rose between 2% and 15% just prior to recessions, which are marked by the gray vertical bars in the chart below.  During the first four recessions on the chart (1969-1982), rates peaked just before or within the recessions.  One interpretation of the chart would be that the Fed was unafraid of its role of “taking the punch bowl away from the party,” to quote a former Fed governor.  That is, the Fed kept raising rates until it saw actual declines in economic data, and only then began to reduce rates.  In these four cases, it is quite possible that the Fed’s actions played a sizeable role in causing the recessions.

Fed Funds Rate

However, in the case of the three most recent recessions, the peak in interest rates preceded recession by 6 to 18 months, so it is not obvious that Fed actions directly led to recessions.  Monetary textbooks might argue that a lag has developed between the rise in rates and a subsequent decline in economic activity.  But does anyone believe that information travels more slowly today than it did 40 years ago?

Further undermining the logic that Fed rate policy causes recessions, the Fed hiked rates a total of 4% during 1983-84, and by a total of 3% during 1994-95, but a recession never occurred in the aftermath.  So, the Fed’s interest rate manipulations alone do not explain the occurrence of recessions.

What prompts the Fed to raise the Fed Funds rate?  Congress gave the Fed the statutory mandate to manage the growth of employment and inflation. Of these two mandates, only an outbreak of inflation would cause the Fed to raise interest rates. Of course, an outbreak of inflation can be either real or perceived, even for the Fed.

Consumer Price Index (CPI)

Looking at inflation data in the chart above, during the first four recessions, inflation peaked and then declined dramatically, which was the Fed’s stated intent.  During the three most recent recessions, inflation also peaked and then declined.  But during the Fed’s tightening cycles of 1983-84 and 1994-95, the Fed hiked rates because they perceived an outbreak of inflation.  But instead, inflation remained stable during those periods.

A defender of the Fed’s policies would assert that the Fed’s actions prevented a subsequent outbreak of inflation.  While that assertion is plausible, it is also a use of counterfactual logic that cannot be proven in a separate, identical experiment.  Counterfactual arguments are rife “would have” or “could have” statements, as in “inflation would have been worse if not for the Fed’s actions.”  Nobody can know whether that statement is true or untrue.

Summarizing the relationship between inflation, rising interest rates, and recessions since the 1960s, inflation always declines during recessions and sometimes declines when the Fed is raising the Fed Funds rate.

Crude Oil

Enter the price of crude oil.  During the 1960s, the price of crude oil was essentially fixed, so the recession of the late 1960s cannot be attributed to a change in the price of oil, as shown below.  However, a spike in oil prices (defined as a doubling or more) preceded all the other recessions since the late 1960s.   Interestingly, during the Fed rate hikes of 1983-84 and 1994-95, oil prices were either falling or relatively stable, which may explain why the economy avoided recession.  Similar to Fed rate hikes, a doubling of oil alone does not cause a recession.   For example, in the period 2010-14, and again 2016-2018, oil prices rose two to three times, yet a recession did not occur.

Crude Oil ($ barrel)

Fed Funds Rate

By putting the two charts in proximity, it becomes clear that a recession only occurs when the Fed Funds rate rose by at least 2.00-2.50% AND the price of crude oil doubled (or more)*. 

When only one of the variables is rising sharply, a false alarm is triggered. For example, there was no recession during the Fed Funds hikes of 1983-84 and 1994-95, because the price of oil was falling or stable.  From 2010-14, the price of oil more than doubled, but the Fed wasn’t raising rates, so there was no recession.  The charts above are annotated with a red X to show instances when only one variable rose significantly.

The important takeaway and economic rationale for this logic are that when the price of money AND the price of energy are rising sharply, it causes a retrenchment in consumer and commercial behavior that leads to a recession.

Current Situation

The knowledge that a rise in both the price of money AND energy is required to cause a recession leaves markets in a precarious position in 2018.  The price of oil has more than doubled, but thus far the Fed has only hiked the Fed Funds rate by a total of 1.50%.  However, public statements by Fed governors, even by historically dovish Fed governors and their own published forecasts signal a further increase 0.75% during 2018.  Based on the historical data, if the Fed follows through on its plans, then the increase in the price of energy and money will make a recession more likely sometime in H2 2018.

The investment implications are obvious, but especially important given the current investment consensus.  The institutional investment management crowd is proclaiming the arrival of an inflation outbreak, as evidenced by an increase in some commodity prices and the break of a 30-year downtrend in interest rates.  The thought process on commodities is circular, because the increase in a major commodity such as oil, which precedes most recessions when combined with a sharp rise in interest rates, is ultimately more likely to lead to a decline in inflation, not an increase in inflation.

The thought process on downtrend lines is understandable.   But as shown below, long-term trend lines for interest rates and inflation have been pierced twice over the past 20 years (1995, 2005), but neither interest rates nor inflation moved systematically higher.  The failure of inflation and interest rates to move higher is probably better explained by aging demographics and an unprecedented burden of debt.

Another notable feature of the current market is the record short position in bond futures (betting on an increase in interest rates), which reflects the consensus line of logic.  The Fed is also part of the consensus, as it is forecasting GDP growth of 2.7% in 2018 and another 2.4% in 2019.  Currently, everyone is standing on one side of the boat, which could be called the Growth and Inflation Scare of 2018 Part II, even though Model, Model on the Wall is forecasting GDP growth of only 1.4% for next year.  As the yield curve flattens further, the forecast for that indicator should fall further.

Conclusions

Textbook monetary theory teaches that a series of Fed Funds interest rate hikes cause a reduction in inflation.  But inflation hasn’t always declined when interest rates rise.  The data shows that inflation always peaks and falls during recessions.  Therefore, it is recessions, not interest rate hikes that are the primary cause of a decline in inflation.

If recessions kill inflation, what causes recessions?  Textbook monetary theory teaches that a series of Fed Funds rate hikes cause recessions.  For the recessions of the 1960s-1980s period, that appears to be true.  However, a lag has developed in recent years between the peak of the Fed Funds rate and the onset of a recession.  Textbooks would also have to explain how the Fed hiked rates significantly during 1983-84 and again during 1994-95 without causing an imminent recession.   Based on the data of the past five decades, Fed rate hikes alone do not cause recessions. 

A better record of predicting recessions is achieved when Fed has hiked rates by 2.00%-2.50%, AND oil prices have at least doubled*.  The price of money and energy are major financial inputs to financial planning, so when they simultaneously rise sharply, consumers and businesses are forced to retrench.  Based on the Fed’s well-communicated strategy, it plans to raise rates another 0.75% during 2018 on top of the previous 1.50% over the past few years.  If crude oil stays above $50-60, both conditions for a recession would be met in H2 2018.

Yet neither the Fed nor any high-profile economist is predicting the beginning of a recession during 2019, let alone 2018.  Answering the inflation/deflation question correctly is the most important issue of the day for investment portfolios.  If recession/deflation arrives before growth/inflation, a major adjustment in expectations, and capital market prices, is coming within the next year. 

*While establishing a range of 2.00%-2.50% may not be specific enough for those who demand a point estimate, we believe that a range is a better approximation of the environment that will begin to increase the probability of a recession. Water turns to gas at exactly 212F, which is a scientific fact because it is repeatable. The economy doesn’t operate like a science experiment. For example, we don’t believe that a rise in the Fed Funds rate of, say, precisely 2.26% will trigger a recession while 2.25% will not.

Model, Model on the Wall; Which is the Fairest of Them All?

“Peter Cook is the author of the ‘Is That True?’ series of articles, which help explain the many statements and theories circulating in the mainstream financial media often presented as “truths.” The motives and psychology of market participants, which drives the difference between truth and partial-truth, are explored.”

The Federal Reserve (Fed) regularly proclaims its decisions on monetary policy are “data dependent.”  More precisely, the Fed uses data as inputs for its economic models, which are thought to describe how the economy functions in the real world.  The complexity of Fed models probably couldn’t be explained in fewer than 50 pages of academic jargon.  But Keynesian economic philosophy, a belief that an economy’s health can be described by the aggregate annual amount of spending (otherwise known as GDP), is foundational to the Fed models.  For 2018, the Federal Open Market Committee (FOMC), which votes on monetary policy, predicts real GDP growth of 2.7%.

The Fed’s regional banks also produce economic research, which can differ from the FOMC’s forecasts.  For example, the Cleveland Fed (CF) also produces an estimate of the upcoming year’s GDP growth, but its model is based on observations of the U.S. Treasury yield curve.  No model can perfectly describe reality, and a potential weakness of CF model is that it is based on a single input; the spread between the yield on the 3-month Treasury bill and the 10-year Treasury bond.

Because the CF model is based on market-based data (not economic data), it is fundamentally different than the FOMC model.  As a result, the difference between the FOMC model and the CF model could be interpreted as a difference between what the FOMC believes and what the market believes.

The CF model is based on 60+ years of historical data between GDP growth and the shape of the yield curve, as shown below.  To achieve the best fit between the data series, the CF model assumes that changes in the spread of the yield curve affect GDP growth one year afterward.  Therefore, the chart below shows the real-time yield spread (orange line) versus GDP growth (blue line) one year later.

The chart below shows the CF model over the past 16 years, which makes it easier to see the changes in the yield curve and GDP growth.  The recent spread of the yield curve produces an estimate of GDP growth for the upcoming year (red line), which has been steady at 1.4% over the past several months.

The FOMC model estimates 2018 GDP growth of 2.7% while the market-based estimate is 1.4%.  So, what is the market seeing that the Fed is missing, or vice versa?  The most likely explanation is the effect of the recent tax cut/reform (TCJA).  The main components of the TCJA were a $200 billion annual tax cut for individuals, plus another $100 billion in additional government spending in 2018.  Keynesian economic theory assumes the total of $300 billion will be spent on items that will increase GDP by 1.5% during 2018 (1.5% equals $300 billion divided by $20 trillion, which is the approximate size of US GDP).

Also, Keynesian theory assumes a multiplier effect for government deficit spending, meaning that the theoretical boost to GDP in 2018 should exceed 1.5%.   But the theoretical multiplier isn’t the same for different types of spending and it isn’t stable over time, so it isn’t a useful concept for this analysis.

Looking at the difference between the FOMC model of 2.7% GDP growth and the CF model of 1.4% growth, the market appears to be saying that the TCJA will have a very little effect on 2018 GDP growth.  How could that be possible?  The market appears to believe that the $200 billion in individual tax cuts will not be spent during 2018; instead, that money will be saved or used to pay down debt, neither of which directly boosts GDP growth in the short-term.

What about the $100 billion in federal deficit spending?  Surely that should create an increase in 2018 GDP growth, under Keynesian assumptions.  It appears the market is no longer driven by Keynesian analysis, because the CF model shows that deficit spending may have very little effect, if any, on GDP growth.

If so, the market’s belief would coincide with the analysis in “Is the U.S. Economy Really Growing?”, which demonstrated a regime change has occurred since 2008.  Before 2008, deficit spending resulted in what Keynesians expected; an increase in GDP that exceeded the amount of deficit spending.  But after 2008, annual increases in federal debt far exceeded annual GDP growth.  The regime change may be the single-most important reason that the Fed has consistently overestimated GDP growth in its forecasts over the past decade.

Does the fact that the Fed has systematically overestimated growth in GDP and inflation over the past decade mean that it will do so in the future?  Not necessarily.  Will the market estimate of 2018 GDP growth be too low?  Again, not necessarily, and for the same reason; the past does not always predict the future.

But there are some clues to which may be more accurate.  The market-based estimate of the CF model incorporates bets by the world’s largest investors to forecast GDP growth (and inflation), and it hasn’t systematically overestimate or underestimated GDP growth over the past decade, as shown in the second chart.  In contrast, the FOMC model incorporates Keynesian assumptions on economic data to forecast GDP growth (and inflation), and it has systematically overestimated GDP growth over the past decade.  When there is a divergence between the two groups, it’s probably a better bet to follow the money, not the academics.

Conclusion 

Today, two models that forecast 2018 GDP growth produce substantially different results. The 1.3% difference in GDP growth forecasts (2.7% – 1.4%) is roughly equal to the theoretical fiscal stimulus of the TCJA (1.5%).

The FOMC model is based on Keynesian assumptions that equate a boost in federal deficit spending with an increase in real GDP.  The FOMC model has consistently overestimated GDP growth over the past decade, probably because it has failed to grasp the regime change that has occurred in the relationship between deficit spending and GDP growth.

The CF model is based on the spread of the yield curve and appears to reflect a high degree of skepticism that federal deficit spending will produce a boost to GDP growth.  Over the past decade, it hasn’t systematically overestimated or underestimated GDP growth.

It is possible that GDP growth is 2.0%, and that both models will be incorrect by the same amount.  But probably not.  As we progress through 2018, the results of the models will converge.  The direction in which the convergence occurs will be crucially important to investors.

The Growth and Inflation Scare of 2018 – Part II

“Peter Cook is the author of the ‘Is That True?’ series of articles, which help explain the many statements and theories circulating in the mainstream financial media often presented as “truths.” The motives and psychology of market participants, which drives the difference between truth and partial-truth, are explored.”

On a day like today, when the holiest of all data points is released (employment situation), it may seem strange to focus on a wider picture.  But we must remember that no single data point can describe the economy at any point in time, let alone describe its future trajectory.  For example, even if the payroll data showed a monthly gain 1,000 or 500,000, the divergence from the recent tendency of 200,000 would be so great that it would be written off as an outlier.  At least until it occurred again next month.  Quite simply, one data point does not a trend make.

If it is difficult to describe the economy, it is even more difficult to describe the consensus view of the economy.  The consensus view is presumably baked into market prices at any given moment.  Successful investing is based on understanding the difference between reality and the perception of reality, which explains why it is difficult to be a successful investor.  That said, it may be possible to detect points at which the gap between the economy and the perception of the economy is at its greatest, which is the subject of this article.

Summarizing Part 1 of this series, a spike in economic activity in late 2017 was largely related to rebuilding in the wake of the destructive hurricanes that hit Florida, Texas, and Puerto Rico last September.  The bond market (and the Fed) appear to be extrapolating the GDP spike into the future, pushing up yields in anticipation of higher growth and inflation.  For example, TLT, the ETF which tracks long-term bond prices, has declined 6% since early September 2017.  In contrast, stocks in the auto, homebuilding, and transportation sectors rocketed higher during Q4 2017. Over the last couple of months most of those gains have been unwound.

The recent decline in the stock market appears to be more closely aligned with reality, but there is another way to understand the debate on reality and the perception of reality.  The Citigroup Economic Surprise Index (CESI, shown below) tracks the difference between actual economic data (reality) and economists’ expectations for economic data (perception of reality).  If economists are “surprised” by data that exceeds their expectations, the CESI rises.  If economists are “surprised” by data that is worse than their expectations, the CESI declines.

CESI oscillates over time as economists alternate between being too optimistic and pessimistic relative to underlying reality.  As a result, the most important CESI chart points occur just after an extreme is reached and is subsequently followed by a reversal, because that’s when expectations are too high/low but are beginning to reverse.  For example, between CESI’s low on June 15, 2017 and its peak on December 26, 2017, economists were consistently too pessimistic about the economy’s performance.  Anyone who had knowledge of that change in mid-2017 could have sold bonds and bought stocks, which would have been profitable.  In fact, stocks rose 10.2% between June 15 and December 26, while bonds were flat during that period.

Since CESI’s peak in December 2017, economists have been too optimistic about the economy’s performance.  Anyone with advance knowledge of that turning point could have bought bonds and sold stocks.  Stocks have indeed declined by 3%, but bonds have declined by even more, or roughly 4%.  But this anomaly may just be a matter of timing.  That is, the current consensus narrative, “synchronized global growth,” may take more time and data before being discarded.  For example, when CESI previously reached rarified air (2011 and 2012), it subsequently reversed all the way into negative territory.  There may also be a seasonal pattern to CESI, because it tends to peak during Q1 and then decline until the middle of the year, with an exception in 2016.  In early 2018, are we simply witnessing a seasonal bout of excessive optimism?

Other data confirms that the synchronous global growth story is getting long in the tooth.  ECRI, which tracks global business cycles, shows that the peak in growth occurred during Q2 or Q3 of 2017.  It is always possible for growth to re-accelerate, but it isn’t clear what set of events, and on what scale, would cause a re-acceleration.

Looking into the future, using ECRIs methodology of leading indicators, the chart below shows that economic growth may decline from current levels.  The top three indicators are leading indicators of economic activity.  When they peaked in early 2014, the bottom blue line (a proxy for current US GDP) began to fall throughout 2015.  The leading indicators bottomed during 2015, foretelling a rise in GDP that began in 2016.   Most recently, the leading indicators peaked in late 2016 and early 2017, which presaged the peak in GDP in late 2017, and which should be followed by further weakness during 2018.

Many would argue with the idea that economic growth will decline during 2018.  That group includes the Fed, which predicts GDP growth of 2.7%, which is well above its 1.9% estimate of long-run US GDP growth.  This argument is based upon a belief that tax cuts and heightened fiscal spending will rev up the economy in 2018.  After all, leading indicators peaked in early 2017, but they couldn’t have predicted that a stimulative tax cut would occur in late 2017, which is what economists call an exogenous shock. This argument has some merit.

But it is also possible that tax cuts are the reason that CESI is registering excessive optimism, which is now reversing.  In this view, a growth impulse from tax cuts will likely be overwhelmed by declining business cycle dynamics plus the well-known headwinds from aging demographics and excessive debt.

Conclusions

CESI is not perfect, but it is a good attempt at measuring the difference between economic reality and the perception of economic reality.  CESI reached a peak in late December 2017, possibly because economists extrapolated an unsustainable spike in GDP growth due to rebuilding after the hurricanes.  In addition, tax cuts and other fiscal stimulus are perceived to kick-start economic growth into a higher gear.  As a result, bond yields shot higher during Q1 2018.  But the auto, housing, and transportation stocks, which benefited most from rebuilding activity, have reversed almost all their gains since September 2017.  The bond and stock markets appear to be in disagreement.

CESI is most useful after it reaches an extreme and then reverses, because it indicates that excessive optimism or pessimism is in the process of reversing.  After peaking in late December 2017, CESI did what it normally does when it reaches such a high level; it reversed.  But CESI is still in positive territory, suggesting it could fall much further, as it did after reaching similar heights in 2011 and 2012.  CESI also exhibits seasonality, because it tends to peak early in the year, followed by a significant decline into the middle of the year.  So the risk that CESI continues to decline during 2018 is high.

Leaving the world of expectations (perceptions of reality), data shows that global growth peaked 6-9 months ago, and leading indicators of future economic growth are pointing downward.  These facts undermine the synchronized global growth narrative.

The destruction of the synchronized global growth narrative is probably the main investment risk of 2018.  If economic data is falling during a period of high expectations for economic growth, disappointment will surely follow, and CESI will decline accordingly.  That is, the “Growth and Inflation Scare of 1H 2018” may be nearing its end.

The Growth and Inflation Scare of 2018

“Peter Cook is the author of the ‘Is That True?’ series of articles, which help explain the many statements and theories circulating in the mainstream financial media often presented as “truths.” The motives and psychology of market participants, which drives the difference between truth and partial-truth, are explored.”

Someone has it wrong.  Is it the bond market or the stock market?  Or the Fed?

As bond yields push up against multi-month highs and long-term levels of technical resistance, stocks have been in decline since peaking on January 26, almost two months ago.  In fact, as shown below, the difference between the 2-year Treasury yield and the Fed Funds overnight rate has been climbing sharply since September 2017, as shown below.  The gap between these two interest rates is a market-based estimate of how much the Fed will increase the Fed Funds rate in the coming months.

Moving from markets to the real-world, data from the transportation sector shows that shipments began spiking in Q4 2017.

A measure of traffic that combines shipments and shipping rates shown even more drastic acceleration.

The Fed agrees with the bond market and the economic data, given the following statement in the most recent FOMC press release and the changes to its economic forecasts for GDP growth in 2018 and 2019.

The economic outlook has strengthened in recent months.”

–FOMC Statement, March 21, 2018

The graph above further confirms this. The Fed now expects GDP growth of 2.7% in 2018 and 2.4% in 2019, up from previous forecasts of 2.5% and 2.1% as of December 2017.  The Fed’s forecast of long-run GDP growth (blue line) remained at 1.8%, meaning that the Fed believes the short-term economic performance will be greater than its long-term projection.

In summary, the Fed and the bond market believe that economic growth is accelerating, justifying a series of interest rate hikes that will stop the economy and inflation from growing too quickly.

However, an alternative explanation for the recent growth spurt is also possible.  The hurricanes that struck Florida, Texas and Puerto Rico in September 2017, and the subsequent rebuilding activity, may have been responsible for a one-time spike in economic activity.  Monthly data from the auto sector confirms the alternative explanation, showing a spectacular rise in auto sales in the wake of the hurricane.  But the most recent statistics show auto sales settling back into the range of the last 18 months.

The stock price of General Motors reflects the alternative explanation.  After the hurricane, GM’s stock rose 30% but has now given back almost the entire gain.

The stock price of home builder Lennar Corp. has also undergone a similar round-trip.

In addition, the declining slope of the yield curve is sending signals of disbelief in the narrative of persistently higher growth. The red circles highlight that every time the curve has flattened and inverted since at least 1980, recession has followed.

If indeed the hurricanes produced a spike in rebuilding and general economic activity and inflation in some sectors of the economy, the Fed seems to agree, given its most recent forecasts, shown below.  The Fed sees decelerating GDP growth and stable inflation over the next three years.


Year-End         GDP%               PCE%           Fed Funds

  • 2018                  2.7                   1.9                   2.25
  • 2019                  2.4                  2.1                    2.90
  • 2020                 2.0                  2.1                    3.40

Chairman Powell’s quote from the most recent FOMC press conference validates the Fed’s inflation forecast:

“There is no sense in the data that we are on the cusp of an acceleration of inflation,” Powell told reporters on Wednesday in Washington. “We have seen moderate increases in wages and price inflation, and we seem to be seeing more of that.”

Interestingly, the column on the right in the table above shows that the Fed expects to continue its program of interest rate hikes through the end of 2020.  That is, the Fed expects to tighten monetary policy at a time that GDP growth is slowing and inflation isn’t a threat to rise.  What could explain the Fed’s reaction?  Let’s quote Chairman Powell again:

“This decision marks another step in the ongoing process of gradually scaling back monetary policy accommodation — a process that has been under way for several years now,” Powell said.

With this quote, we are getting closer to the primary explanation of the Fed’s motives.  Maybe the Fed isn’t hiking rates to counteract a rise in GDP growth and inflation.  Instead, the Fed is probably focused on preserving its reputation as a powerful economic actor.

Consider the following scenarios.  Fed interest rate hikes today provide more room to cut them if a recession were to occur at some point in the future.  In that scenario, the Fed rides to the rescue with rate cuts, and could cut rates as an intermediate step before another bout of QE.  That’s important because QE is increasingly being perceived as a primary determinant of income inequality.

It is also possible that recession occurs just after the series of rate hikes.  In that scenario, the Fed’s rate hikes would be perceived as causing a recession. That may not be the ideal scenario because the Fed would take the blame for a “policy mistake.”

However, the third scenario is the worst one.  In that scenario, a recession occurs while the Fed’s interest rate policy is still “accommodative.” That’s a problem for the Fed for two reasons.  First, recessions aren’t supposed to happen when Fed policy is accommodative because it would undermine the main theoretical justification for the Fed’s manipulation of interest rates.  Second, a recession during an era of accommodative Fed policy would leave the Fed very little ammunition to fight it. It is difficult to reduce rates dramatically if they are already on the floor.  Another round of QE, and the political baggage that comes with it would be the likely response.

To be sure, the Fed cares about its executing on its mandates of controlling GDP growth and inflation, however, in conflict, those mandates may be.  But it cares even more about making sure it keeps those mandates, which can only be accomplished if Congress perceives the Fed’s actions actually have a positive impact.  Without the mandates, it can’t execute on them. Therefore, the worst-case scenario for the Fed is for a recession to occur while its interest policy is accommodative.

Conclusions  

The conventional wisdom is focused on an upcoming economic boom which will inevitably drive inflation higher, forcing the Fed to respond with higher interest rates in coming years.  In this view, stocks can continue to rise because the boom will produce an upswing in corporate earnings.  It is possible that rising rates could halt a stock market rally, but if the bond market doesn’t have a tantrum, conniption, or some other emotional reaction to the rise in expected growth, then stocks will be good investments.  For bonds, disaster will be averted because modest capital losses in the bond market will be offset by annual coupon interest.

An alternative explanation is that economic growth is already slowing from a one-time spike that occurred in the wake of the hurricanes.  Transportation costs have spiked higher as goods needed to be physically transported to the affected areas.  But it is likely that transportation costs will retreat soon if it hasn’t already begun. Similarly, the stocks of auto and homebuilding stocks have retraced most of the gains they made shortly after the hurricane.  A recession is not necessarily in the cards for 2018 or 2019, but expecting a sustained boom in coming years based on hurricane-related activity is to extrapolate a one-time event.  In the alternative explanation, stocks and junk bonds are expensive while Treasury bonds are oversold and due for a trading bounce, and maybe even more.

As to the Fed, its behavior is better explained by concern for its institutional reputation than by a change in economic outlook.  The Fed plans on hiking rates in 2018, 2019, and 2020, even though it forecasts that GDP growth will decelerate and inflation will remain stable. In those conditions, the Fed would be expected to cut rates, not hike them.

Is The U.S. Economy Really Growing?

“Peter Cook is the author of the ‘Is That True?’ series of articles, which help explain the many statements and theories circulating in the mainstream financial media often presented as “truths.” The motives and psychology of market participants, which drives the difference between truth and partial-truth, are explored.”

Most people are aware that GDP growth has been lower than expected in the aftermath of the Global Financial Crisis of 2008 (GFC).  For example, real GDP growth for the past decade has been closer to 1.5% than the 3% experienced in the 50 years prior to 2008.  As a result of the combination of slow economic growth and deficit spending, most people are also aware that the debt/GDP ratio has been rising.

However, what most people don’t know is that, over the past ten years, the dollar amount of cumulative government deficit spending exceeded the dollar amount of GDP growth.  Put another way, in the absence of deficit spending, GDP growth would have been less than zero for the past decade.  Could that be true?

Let’s begin with a shocking chart that confirms the statements above, and begins to answer the question.  The black line shows the difference between quarterly GDP growth and the quarterly increase in Treasury debt outstanding (TDO).  When the black line is above zero (red dotted line), the dollar amount is GDP is growing faster than the increase in TDO.  From 1971 to 2008, the amount of GDP typically grew at a faster rate than the increase in TDO, which is why the black line is generally above the red dotted line.

Chart 1

During the 1971-2008 period, inflation, budget deficits, and trade deficits varied widely, meaning that the relationship between GDP growth and TDO was stable even in the face of changes in other economic variables. Regardless of those changing economic variables, the US economy tended to grow at a pace faster than TDO for four decades.  The only interruptions to the pattern occurred during recessions of the early 1980s, early 1990s, and early 2000s when GDP fell while budget deficits did not.

The pattern of GDP growth exceeding TDO changed after 2008, which is why the black line is consistently below the red dotted line after 2008.  A change in a previously-stable relationship is known as a “regime change.”  Focusing first on 2008-2012, the increase in TDO far exceeded GDP growth, due to an unprecedented amount of deficit spending compared to historical norms.  Focusing next on 2013-2017, the blue line has been closer to the red dotted line, meaning that the dollar amount of GDP growth was roughly equal to TDO.

If the pattern of the past was in effect, the black line should have been far above the red dotted line for most of the entire period of 2009-2017, because it would be expected that a recovering economy would have produced an excess of GDP growth over TDO.  But that didn’t happen.  This article will not speculate on why there was a regime change.  Instead, this article is focused strictly on identifying that a regime change occurred, and that few people recognize the importance of the regime change, which is probably why it persists.

Taking a quick detour into the simple math of GDP accounting, the level of GDP is calculated by adding up all forms of spending:

GDP = C + I + G + X

In the equation above, C is consumer spending; I is investment spending by corporations; G is government spending; and X is net exports (because the US has become such a heavy net importer, X has been a subtraction from GDP since 2000).

For context, at the end of 2017, the level of US GDP was $19.74 trillion, per the Bureau of Economic Analysis (BEA).  Of that $19.74 trillion, the Congressional Budget Office (CBO) calculated that the US government spent $3.98 trillion, all of which counts toward GDP. In 2017 the government borrowed $516 billion, meaning that the government spent more than it received via taxes and other sources.  The main insight in understanding how the government calculates GDP is that all government spending counts as a positive for GDP, regardless of whether that spending is financed by tax collections or issuing debt.

Because deficit spending is additive in the calculation of GDP, it makes sense to compare the amount of deficit spending to the amount of GDP growth produced each year. The first four columns in the table below show the annual GDP, the annual dollar change of GDP, the total amount of Treasury debt outstanding (TDO) and the annual dollar change of TDO.  Comparing the second and fourth columns, it is easy to see that the annual increases in TDO regularly exceed the increases in GDP.

Chart 2

The final column to the right shows the increase in TDO as a percentage of the annual change in GDP growth.  When the ratio is greater than 100%, the increase in TDO is responsible for more than 100% of annual GDP growth.  Reinforcing the message of Chart 1, the annual increase in TDO exceeded annual GDP growth in each of the years from 2008-2016. The only year in which annual GDP growth was greater than the increase in TDO was in 2017, possibly due to the debt ceiling caps, which have now been lifted.

The cumulative figures are even more disturbing.  From 2008-2017, GDP grew by $5.051 trillion, from $14.55 trillion to $19.74 trillion.  During that same period, the increase in TDO totaled $11.26 trillion.  In other words, for each dollar of deficit spending, the economy grew by less than 50 cents.  Or, put another way, had the federal government not borrowed and spent the $11.263 trillion, GDP today would be significantly smaller than it is.

It is possible to transform Chart 1, which shows annual changes in TDO and GDP from 1970-2017, into Chart 3 below, which shows the cumulative difference between the growth of TDO and GDP over the entire period from 1970-2017. The graph below clearly shows the abrupt regime change that occurred in the aftermath of the GFC.  A period in which growth in GDP growth exceeded increases in TDO has been replaced by a period in which increases in TDO exceeded GDP growth.

Chart 3

Unfortunately, extending the analysis forward tells us the problem will only get worse.

Chart 4

Over the entire period from 2008 to 2021, the increase in TDO will exceed GDP growth by $7.531 trillion ($15.843 trillion of TDO compared to $8.312 trillion of GDP growth).  While most people would accept that deficit spending is required for short periods to offset economic disturbances, even John Maynard Keynes wouldn’t expect it to become the norm.  Nor would he expect that a dollar of deficit spending would produce less than a dollar of GDP growth.

Investment and Policy Implications

The purpose of this article is to clarify the changing relationship between the dollar amounts of GDP growth and budget deficits, which are funded by TDO.  If indeed GDP growth has become reliant on budget deficits post-2008, there are many implications for investment policies across all asset classes. For example, might poor organic growth in the private sector explain the unexpectedly-low inflation environment and historically-low capital investment?  If so, what are the implications for stocks and bonds?

Also, government policy should acknowledge the regime change and adapt policies accordingly. If massive deficit spending is required to produce a “positive” sign for GDP growth, is it possible that the private sector of the economy is not growing but shrinking?  Is the private sector’s health now completely reliant on continued government deficits?  If so, is there a limit to the government’s ability to run deficits by issuing bonds?  If a dollar of increase in debt leads to less than a dollar of GDP growth, should the US continue to borrow?  Should the Fed raise rates because of increased fiscal stimulus if the link between deficit spending, GDP growth, and inflation has experienced a regime changeCan any economic theory explain what is going on?

These questions will be addressed in upcoming articles.

Conclusions

  • All government spending boosts GDP calculations, regardless of whether government spending is financed by tax collections or deficits financed by debt issuance.
  • Isolating the interaction between increases in TDO and the dollar amount of GDP growth, the data show a regime change post-2008 compared to the period 1971-2007.
  • In the period 1971-2007, the dollar amount of GDP growth exceeded increases in TDO except in years in which the economy was in recession.
  • In the period 2008-2017, annual increases in TDO regularly exceeded the dollar amount of GDP growth, which remarkably occurred during years that GDP was calculated to be growing.
  • In the period 2008-2017, the cumulative increase in TDO was a multiple of cumulative GDP growth. The dollar amount of GDP growth was completely dependent on deficit spending.
  • The efficiency of each dollar of deficit spending is declining, because the dollar amount of TDO is greater than the dollar amount of GDP growth.
  • In the period 2018-2021, the increase in TDO will continue to exceed GDP growth, per forecasts made by the BEA and CBO. That is, GDP growth will be dependent on continued deficit spending.
  • Importantly, if the economy slips into recession, it is possible TDO will grow at well over $2 trillion per year, meaning that the gap between TDO and GDP will get much larger.

Corporate QE : What It Is & Isn’t

“Peter Cook is the author of the ‘Is That True?’ series of articles, which help explain the many statements and theories circulating in the mainstream financial media often presented as “truths.” The motives and psychology of market participants, which drives the difference between truth and partial-truth, are explored.”

Corporate stock buyback programs (CSBs) are one of two tools used by corporate CFOs who aim to “return capital to shareholders.”  The other main tool is dividend policy.  Dividends are prized by investors because the value of any investment is determined by the set of cash flows received over time, and dividends are the receipt of cold, hard cash.

CSBs, on the other hand, are not really a return of capital or of cold, hard cash; they are a use of a company’s capital (generated by profitable operations or by borrowing) to directly intervene into financial markets and shrink the number of shares outstanding.  By shrinking the number of outstanding shares, the CSB raises earnings per share (EPS), which should theoretically raise the stock price (assuming the company earns more on its assets than its cost of borrowing).

Today, it might seem like CSBs have been around forever.  In fact, they weren’t.  In the aftermath of the Roaring 20s and the Crash of 1929, CSBs were seen as blatant “stock manipulation” schemes and were outlawed.  It wasn’t until the 1980s that the prohibition on CSBs was seen as archaic, and they were legalized once again.  The only restrictions on CSBs are that they can’t operate during the first or last half-hour of the trading day, and that they can’t operate for a few days around significant news events, such as quarterly earnings reports.  By creating these restrictions, regulators are effectively admitting that CSBs affect the price of the stock they are accumulating.  So, in addition to shrinking the number of shares outstanding, CSBs also push stock prices higher, but to an unknown degree.

In a normal market for any product or service, buyers attempt to buy at the lowest price and sellers attempt to sell at the highest price.  In contrast, a CSB typically promises to buy a fixed number of shares during a fixed period, without regard to price.  That behavior is a powerful signal to other financial market participants that the true goal of CSBs is to move the price higher.  In other words, CSBs explicitly attempt to distort market prices, because they use the same method and attempt to achieve the same goal as the Fed’s QE programs (buying a fixed quantity during a fixed period without regard to price). Hence, CSBs are effectively “Corporate QE.”

Goldman Sachs estimates the flow of funds into and out of the stock market on the premise that fund flows can drive the direction of stock prices.  Its most recent chart of estimated flows is shown below.

Since 2010, CSBs have consistently been the largest flow into or out of the US stock market.  Also, they don’t behave as other market participants because other buyers want to pay the lowest price, not just any price.  So, considering the size and intensity of their buying, CSBs have more influence on stock prices than pension funds, ETF investors, foreign investors, insurance companies, mutual funds, and individual investors.  In fact, in many years CSBs alone are larger than the activities of those investor types combined.  For example, since 2010 CSBs have accounted for somewhere between 120% and 300% of total net stock market annual inflows.  It is doubtful that regulators anticipated that result when they legalized CSBs in the 1980s.

CSBs are also notable for their consistency in both direction and amount.  Most of the other types of stock market investors may buy one year and sell another year.  Or, in the case of pension funds, they may be consistent sellers to fund retiree benefit payments, but the amount of selling varies annually.

In summary, looking at the activity of all stock market investors, CSBs are most probably the largest determinant of stock prices.  Put another way, corporate management teams, whose compensation is significantly based on lifting the stock price, execute CSBs, which are the largest determinant of stock prices.  This combination of compensation arrangement and responsibility for executing CSBs opens the potential for a “principal-agency” conflict of interest.  If corporate managers (agents) are skilled at buying stock on behalf of shareholders (principal), then CSBs may not produce a conflict of interest.  But as we will see, the data actually shows a lack of skill by corporate management at executing CSBs.

The same type of table from Goldman Sachs is shown below, but this one was produced in mid-2016 and stretched back to 2008.  The data on corporate behavior is near the bottom, highlighted by the red oval.  Focusing on 2008 and 2009, a new pattern of CSB behavior emerges.

Instead of being buyers, corporations were net sellers during 2008 and 2009.  How could that be?  Think of CSBs as a discretionary purchase, just like a decision made by any purchaser.  When your cash flow is high, you can afford to buy things.  When your cash flow is low, you don’t buy discretionary items.  In fact, you might be forced to sell previous purchases or even borrow money to meet current expenses.

So too it is with corporations.  Their CSBs are discretionary.  Corporations buy stock when cash flow is high, and they are forced to sell stock when cash flow is poor.  Because cash flows are correlated with stock prices, CSBs buy stock when prices are high and sell stock when prices are low.  In other words:

  • The level of CSB purchases are dependent on fluctuations in the business cycle, and
  • Corporations tend to buy high and sell low, so their skill at market-timing is poor.

While these might seem to be shocking statements, additional historical data in the chart below validates them.

Source:   Societe Generale

Note:   The chart ends in 2015, but separate data show a recent plateau in both buybacks and debt issuance

The chart above shows “net” buybacks (blue line), so it differs slightly in magnitude from the Goldman data, but it shows the same directional pattern of rising and falling with the business cycle.  In addition, this chart includes data on the change in corporate debt (red line).   Thus, we can draw the following conclusions:

  • In the 1990s, the level of CSBs and debt issuance was lower, and they did not rise and fall at the same time.
  • Since 2000, CSBs show a clear pattern of increased buying during business expansions and a decrease during recessions, which occurred in 2001 and again in 2008-09. Because stock prices are higher during expansions and lower during recessions, CSBs indeed appear to be poor market timers.
  • Corporations increase their debt during business expansions and pay down debt during recessions. Because interest rates are higher during expansions and lower during recessions, corporations also appear to be poor market timers when it comes to the issuance of debt.
  • Given the similarity in magnitude and direction of the blue and red lines, many corporations borrow money to fund CSBs. While the Fed’s low-interest rate policy reduced the cost of borrowing post-2009, borrowing money to fund CSBs also occurred prior to 2009, so factors other than Fed policy are relevant.
  • The fluctuations in CSBs and debt are becoming greater over time, meaning that corporations are doing more of what they are poor at doing.

The preceding charts demonstrate the “big picture” analysis of aggregate CSBs.  But specific sectors may experience recession even while the economy is growing.  After the crash of oil prices from $100 to $26 that occurred between November 2014 and February 2016, energy companies were forced to sell stock at half the price that they had purchased in CSBs before November 2014 (e.g., Hess Corp.).  Similarly, several years ago retailers used CSBs to purchase stock at much higher prices than today’s prevailing prices.  Losses can run into the billions of dollars for individual companies (e.g., Macy’s Inc.).  In each case, instead of diverting cash flow into financial engineering tactics such as CSBs, management could have been investing cash flow to improving their operating businesses.

“Corporate QE?”  

QE, as practiced by the Fed, is the policy of issuing currency out of thin air to buy government bonds and mortgage-backed securities.  Globally, central banks issue currency out of thin air to buy a variety of other securities, including corporate bonds, junk bonds, and stocks.  Many central banks, including the Fed, directly intervene in financial markets buy a specific quantity of securities during a specific period, and with no price limit.  Regardless of what is purchased, the goal is to push the price higher and yields lower, because central banks have stated their beliefs that high financial prices give people confidence to spend more than they otherwise would, increasing GDP growth in the process. This is known as the Wealth Effect.

Corporate QE, as practiced by corporations executing CSBs, means issuing bonds at low-interest rates or using cash reserves to purchase stock in financial markets.   So Corporate QE has an opportunity cost that central bank QE doesn’t.  But the effect of Corporate QE on market prices is similar to QE practiced by central banks.  CSBs directly intervene in stock markets to buy a specific amount of stock during a specific period, and with no price limit.  Because CSBs are the largest inflow to the stock market, they probably succeed in push stock prices higher, treating investors to gains they wouldn’t otherwise have.  During this part of the cycle, CSBs seem like a great idea, and the principal-agency problem is not visible.

But that’s only half the story. When the business cycle rolls over, cash flows decline and CSBs are suspended.  If things get really bad, the data from the past 20 years shows that corporations are forced to issue stock at much lower prices than the prices paid by CSBs. Unfortunately, the goal of “returning cash to shareholders” via morphs into borrowing or issuing equity to survive. During this part of the cycle, previously-executed CSBs don’t seem like a very good idea, and the principal-agency problem is highly visible.

The recent tax reform legislation included a provision for companies to repatriate cash held overseas.  There is some debate as to whether the repatriated cash will be used to fund new CSBs, but that’s what happened in a similar change in repatriation rules in 2005.   Some estimate that hundreds of billions of dollars will be repatriated in coming months/years to fund CSBs.

If so, incremental Corporate QE will soon be in full swing to counteract the unwind of QE by the Fed and the upcoming tapering of QE by the ECB and BOJ, at a time when even Janet Yellen admits that stock valuations “are on the high side.”  Confirming this suspicion, Goldman Sachs recently stated that, during the market swoon in early February, the GS buyback desk had its “most active week in history.”  Corporations are “buying high” once again, just as they did ten years ago, and Corporate QE was at least partially responsible for producing the stock market’s best weekly gain in seven years.

Conclusions 

CSBs, unlike QE, incur an initial cost, because corporations fund CSBs by issuing debt or with cash from operations that could have been invested elsewhere.  But CSBs and QE share a method of price-insensitive buying that is unlike the behavior of any other market-based buyer; they buy a fixed amount during a fixed period, with the goal of buying at ever-higher prices.

In analyzing the success of CSBs, or for that matter, QE, one should wait until a full cycle before declaring a judgment.   Unfortunately, the data shows that CSBs, in aggregate and over time, buy high and sell low.    When cash flow and share prices are high, CSB buying is at its highest.  When cash flow and share prices are low, CSB buying is reduced or even reversed by share issuance.  Because the fluctuations of CSBs and debt issuance have increased over the past 20 years, corporations are doing more and more of something they do poorly.  Over an entire business cycle, CSBs may destroy value, not create it.

If so, one explanation is the principal-agency problem, which occurs when the agent has different incentives than the principal.  Among large companies, it is common for a significant portion of executive compensation (stock options, incentive rewards, etc.) to be tied to the stock price.  If the tenure of senior corporate management (agent) is shorter than a full business cycle and its ups and downs, the principal-agency problem for the shareholder (principal) will tend to be greater.

“Rising Rates Will Kill The Stock Market Rally!” – Is That True?

“Peter Cook is the author of the ‘Is That True?’ series of articles, which help explain the many statements and theories circulating in the mainstream financial media often presented as “truths.” The motives and psychology of market participants, which drives the difference between truth and partial-truth, are explored.”

Summing up the current conventional wisdom:

  1. Global GDP growth has bottomed and is accelerating systematically higher,
  2. Which will cause the inflation rate to accelerate higher.
  3. Bond markets hate higher inflation, so interest rates have bottomed and will move even higher.
  4. The stock market, dependent on low rates for high valuations, will fall if rates move higher,
  5. Which is why the stock market peaked on January 26, 2018, and then declined dramatically,
  6. Ushering in an era of systematically higher volatility

In our last article “GDP Growth Driving Rates Higher!” – Is That True?, we tackled the first three bullet points above, critiquing whether the current conventional wisdom contains flaws.  A review of the data showed that the main global economic zones (US, Eurozone, China, Japan) are growing more slowly than they did 10-20 years ago, and that GDP growth in each of those zones is currently within the range of GDP growth since 2008.   Further, debt and demographics have and will continue to constrain GDP growth and inflation in each of those zones.  So it is difficult to see why GDP growth and inflation would shift into a higher gear.

If this view is correct, the recent rise in US long-term interest rates will not persist, at least based on economic fundamentals alone.  More likely, the recent rise in US long-term rates may be a transitory event based on the short-term behaviors of market participants who seek to “call the bottom” in interest rates and act on that belief.  Or, the rise in rates could be the beginning of credit risk being priced into US Treasury bonds, the result of simultaneous experiments of unwinding of QE while undertaking a borrowing binge during a time in which the ratio of debt to GDP is greater than 100%.  Neither of those has been previously attempted, let alone at the same time.

Below we tackle bullet points four through six, in which the consensus view is that rising interest rates must cause a decline in stock prices.  Specifically, this line of logic connects the dramatic fall in stock prices after January 26, 2018 with the recent rise in interest rates.  Further, it is believed that the rise in rates and the explosion in volatility (VIX index) will usher in an era of systematically stock market volatility, and quite possibly, economic uncertainty.

Stocks Will Fall If Rates Move Higher

In a previous article the data since 1880 showed that extremely high stock market valuations have occurred when interest rates weren’t at secular lows (1929 and 2000), which debunks today’s highly-confident narrative that stocks are high because of low interest rates.  The graphic evidence is shown below.

Source:  Robert Shiller

Extending that logic, stock prices shouldn’t necessarily fall because of a rise in interest rates from low levels.  But that logic certainly isn’t supported by the consensus belief that a rise in rates will cause stock market prices to fall.

So if the experience of 140 years of data isn’t your cup of tea, then maybe more recent experience will be persuasive.  Since 2009, there have been five episodes of sharply-rising long-term interest rates, and each time stock prices didn’t fall; they rose.   The data below uses the price change of TLT, the 20+ year bond ETF, compared to the price change in the S&P 500 index.

Calendar Year 2009

  • Bonds   -22%
  • SPX   +10

June 2012-December 2013

  • Bonds       -20%
  • SPX       +35

1H 2015

  • Bonds           -16%
  • SPX          + 1

2H 2016

  • Bonds       -15%
  • SPX        + 7%

Dec 15, 2017-Feb 2018

  • Bonds           -9%
  • SPX          +2

It is understandable that investors believe interest rates are a factor in stock prices on both a theoretical and practical level.  However, the fact that the signs for bonds and stocks are opposite in each episode above suggests that other factors than interest rates are driving stock prices.  The main suspects are global QE and corporate stock buyback programs, which are effectively QE by a different name.  Both of those programs explicitly focus on lifting financial market prices, are still operating in full swing, and are probably succeeding.

Which Is Why The Stock Market Peaked on January 26, 2018

Now, by zeroing in on the period beginning January 26, which was the last all-time high made by the S&P 500, it is possible to make the signs for stocks and bonds be the same.  In fact, even the magnitude is the same!

January 26, 2018-February 22, 2018

  • Bonds -5.6%
  • Stocks -5.6

However, using data from a one month period of stock and bond market history, it is possible to arrive an any conclusion.  That’s called data-mining.

It is far more plausible to explain the recent drop in the stock market with the extinction event of short-volatility ETFs such as XIV.  As shown below, a peculiar coincidence began in mid-January; the volatility index (VIX) began to rise, even though the S&P 500 Index (S&P) was rising.  Normally, these two indices move in opposite directions.  The obvious conclusion is that someone was accumulating a long position in volatility at a time they normally would be punished for doing so.  Did they know something in advance?

It appears so, because things snapped back to normal at the beginning of February.  VIX quadrupled in just a few trading sessions while stock prices crashed 10% over 6 trading sessions.

After seeing these two charts, what seems to have caused stock prices to fall; rising interest rates or leveraged positions in short-volatility ETFs?  The latter seems much more likely a bigger factor than the former.  Put another way, a problem in market-structure (excessively leveraged ETFs) is more likely to have caused stock prices to fall than a change in economic fundamentals (poor economic or earnings reports) or a relatively small change in interest rates.

For those who prefer mysteries, stories will probably emerge in coming weeks and months that a classic short-squeeze in volatility was triggered by market participants who were large enough to engineer one.  The incentive to do so?  On the other side of their trades were owners of XIV and other short-volatility ETFs, who permanently lost $3-4 billion in capital due to their penchant for shorting volatility at historically low levels and using vehicles that would be “stopped out” if VIX rose by 80-100% in a single day.  In a zero-sum world, if someone lost $3-4 billion, someone made $3-4 billion.

Ushering In An Era Of Systematically Higher Volatility.

By now, it should be clear that there is a difference between poorly-constructed volatility ETFs causing a disturbance in the S&P 500’s habitual path higher, and actual economic events (e.g., poor economic and earnings reports) causing a disturbance in the S&P 500’s habitual path higher.  We say “habitual path higher” because just one month ago, the financial press was filled with stories of tax reform, stock buybacks, and central bank put options as justifications for the inevitable rise in stock prices and disappearance of volatility.  In response, Wall Street strategists were happily raising stock index price targets, bolstered by historical data showing that when January is a positive month, it is almost certain that the remainder of the year will be positive.

Just a few weeks later, the financial press is looking for scapegoats for lower stock prices over the past month, the most prominent of which is rising interest rates.  But a much simpler explanation is the popularity of selling volatility at low prices and being forced to buy it at high prices.  That chain of events had been a risk over the past few years as trading volumes in volatility ETFs exploded higher, the same way that a bomb with a fuse is risk until the fuse is lit.  But, for whatever reasons, the fuse lit sometime in late January and the bomb exploded in early February; the risk became a reality.  The mathematical relationships between rising volatility indices and lower stock prices then took over, causing a temporary imbalance of sellers which pushed stock prices down sharply.  The tail wagged the dog.

In the aftermath of a 10% decline, it then became time for corporate stock buybacks and global QE programs, which are the largest inflows to stock markets, to do what they usually do; levitate prices for the apparent benefit of shareholders and society at large.  Goldman Sachs said as much when observing that a week in early February was the most active in corporate buyback history.

In fact, nobody knows for sure whether the volatility spike of early February will usher in an era of systematically higher stock price volatility.  But here are some observations:

  • Volatility almost certainly had to rise because during 2017, it had reached historic lows and stayed there. Therefore, it isn’t difficult to predict that volatility in 2018 will probably be higher than in 2017.
  • Observing market volatility is different than identifying its cause with a high confidence level. Did volatility in stock prices rise because of underlying economic problems, the engineered extinction of short-volatility ETFs, rising interest rates, or something else such as political intrigue?
  • The data leads us to believe that short-volatility ETFs were the most likely suspect, and not rising interest rates as is commonly believed. If so, the rise in stock market volatility is likely be temporary, not permanent.
  • If volatility reverts to historically low levels, it will reduce the “income” from shorting volatility. But such a return to the 2017 environment increases the probability of another extinction event for another crop of short-volatility strategies that sell low and could be forced to buy a lot higher.
  • Short-volatility speculators who survived February 2018 will probably make more “income” from shorting volatility in 2018 than they did in 2017, simply because the VIX is higher than it was (around 20 instead around 10). Unless volatility spikes again, and possibly for an even longer period, exposing more highly-leveraged bets on short-volatility strategies, and creating even larger losses.
  • Based on the data of the past nine years, rising interest rates have been associated with higher stock prices, not lower stock prices, with two big assists from corporate buyback programs and global QE, which are intended to drive stock prices higher. Both are still operative, although global QE is predicted to fade to zero in the next few quarters.

Back in the real world, at some point the business cycle will roll over, leading to a recession, which is more likely to kill the stock market rally than a rise in interest rates from historically low levels.  That’s when you can expect a systematic rise in stock market volatility along with a bear market in stocks.  But a downward turn in the business cycle isn’t evident, at least not yet.

Conclusions

It is certainly possible that the conventional wisdom is correct.  In that view, the rise in interest rates caused a fall in stock prices, as evidenced since January 26, 2018, and will usher in a period of systematically higher volatility.

However, a review of the long-term data shows that high stock market valuations have occurred when rates were not at secular lows (1929 and 2000).  So extremely low rates don’t solely explain high stock market valuations, and rates rising from low levels shouldn’t solely explain a decline in stock valuations either.  Even more confounding for those who believe interest rates are the primary driver of stock prices, looking back at the past nine years, stock prices have risen during five periods of sharply-rising long-term interest rates, including the period of the past two months.

If global QE and corporate stock buybacks are behind the odd coincidence of higher interest rates and higher stock prices over the past nine years, both are still operative today, so it isn’t clear why rising rates should overwhelm these influences now.  Global QE is projected to fade out sometime in the coming year (we’ll believe it when we see it), but corporate buybacks, as the largest inflow to stocks, will only fade if the business cycle rolls over and cash flows are pinched, just as occurred during the past two recessions.

A better explanation for the recent decline in stock prices lies in the implosion of short-volatility strategies.  If that is indeed the explanation, the observed rise in stock market volatility is a temporary market phenomenon, and not one caused by events in the real world.  Nor should it cause events in the real world. Yes, stock market valuations are extremely high, but that observation is not news and has been true for quite some time, so it doesn’t explain why stocks fell sharply after the January 26, 2018 peak.

Undoubtedly, some volatility shorts were culled from being able to ply their trade in the future, as investors short-volatility ETFs lost $3-4 billion in market value in a short period of time.  But Apple Inc. has 5.1 billion shares outstanding, so the rout in short-volatility ETFs is smaller than small changes in Apple’s share price, so the risk is to overstate its importance.

Was the short-volatility ETF debacle and the associated market decline a warning shot like the Bear Stearns hedge fund blow up in early 2007?  Are larger short-volatility positions lurking but not yet seen?  Was the stock market decline part of a market-topping process that signals a change in trend from up to down?  These are possibilities, but right now we don’t have enough evidence to draw those conclusions, especially in the absence of persistent weakness in the economic environment.   Upcoming economic and technical data will provide clues to answer these questions, and to whether investment policies should change accordingly.

“GDP Growth Driving Rates Higher!” – Is That True?

“Peter Cook is the author of the‘Is That True?’ series of articles, which help explain the many statements and theories circulating in the mainstream financial media often presented as “truths.” The motives and psychology of market participants, which drives the difference between truth and partial-truth, are explored.”

Summing up the current conventional wisdom:

  1. Global GDP growth has bottomed and is accelerating systematically higher,
  2. Which will cause the inflation rate to accelerate higher.
  3. Bond markets hate higher inflation, so interest rates have bottomed and will move even higher.
  4. The stock market, dependent on low rates for high valuations, will fall if rates move higher,
  5. Which is why the stock market peaked on January 26, 2018, and then declined dramatically,
  6. Ushering in an era of systematically higher volatility

In this article, we will investigate the data behind the first three assertions related to GDP growth, inflation, and the bond market and offer explanations that differ from the conventional wisdom. Next Friday, we will continue this theme with a discussion of the following three assertions.

  1. Global GDP Growth Is Accelerating

Unless GDP can be exported from another planet to Earth, the main drivers of global GDP growth are in four large economic zones.  Here are the past 30 years of GDP growth in the U.S……

The past ten years in China……

The past 20 years in Europe…..

and Japan.

In summary, each of the main economic zones are growing at lower rates than they did 10-20 years ago.  While they are each trending slightly higher after bouncing off recent troughs in early 2016, all are well within a range established since the Global Financial Crisis (GFC).

To believe that global GDP growth will move systematically higher in coming years, you need to believe that something fundamental has changed to produce higher economic growth.  You would also need to believe that cures have been found to reverse the two secular constraints that are primarily responsible for the slow-growth, low inflation environment in each of these regions, which are:

  • High and increasing indebtedness
  • Rapidly-aging populations

The first bullet point was documented in a 2012 study Rinehart and Rogoff, in which they observed an association between government with high debt-to-GDP ratios (90%+) and subsequent period of slower GDP growth.  Most people can grasp the idea that excessive debt constrains their ability to spend in the future. It is no different for a government in the long run.

The second bullet point is intuitive because of declining spending patterns as people age.  The concept is most clearly demonstrated by the economic performance of Japan over the past 20 years, but many other countries (China, US, and many European countries) are on this same path.  But a deep dive into each of these issues is beyond the scope of this article

  1. Rising Inflation

Below is the chart of US annual inflation rate since the mid-1990s’ during which time it has fluctuated between 1.0% and 2.4%, and is currently at 1.5%.  Nothing significant seems to have changed here.

Business leaders don’t sense an imminent change in inflation in the next 12 months either.  Their expectations have ranged between 1.7% and 2.1% over the past year.

Consumers don’t seem too worried about a rise in inflation either.  The current expectation is a little below 3%, which is near the average of the past 20 years, in addition to being consistent with the past several years.

Sticking with the theme of the consumer, real income in the US has risen in recent years, and is near the top of the range of -3% to +4% which has existed over the past 20 years.  Could this be inflationary?

It depends.  Consumers aren’t doing anything out of the ordinary compared to the recent or distant past, as the annual growth in retail sales is stuck in the middle of the range of the past few years.

If anything, it is possible that the spike higher in retail sales during Q4 2017 was caused by rebuilding activity after the Florida hurricane and Texas hurricane/flooding events in early September as well as holiday-related spending.  If so, that blip is beginning to reverse, as shown by the most recent retail sales data.

  1. Bond Market Reaction

Summing up the data presented so far, neither global GDP growth nor US inflation are systematically higher, and to believe they will rise sharply out of the range of the past 10-20 years, you would have to believe that GDP growth and inflation will overcome the two main constraints on economic growth, which are a high and rising debt burden, and an aging population.

So why would interest rates be moving higher over the past couple of months, and why would there be so much noise about that fact in the financial media?  We can think of two alternative explanations.

The first explanation is behavioral, meaning that it is rooted in how and why humans act and interact in markets, a subject of focus for the authors of the Epsilon Theory articles.  The chart below shows the history of the 10-year Treasury bond yield over the past 140 years.

Source:  multpl.com

Imagine the professional competition to predict the peak in interest rates in the early 1980s.  To win that competition, you would have somehow had to keep quiet (and keep your job) while rates rose from 7% to 15%, and then had to become a very lonely bull among a legion of bears at the precise peak in rates or shortly thereafter.  Today, very few remember the even fewer number of bulls that precisely called the peak in interest rates.

In beautiful symmetry, today the professional competition to predict the bottom in interest rates is fierce.  To accomplish that feat, you could not have previously called a bottom in rates, because you only get one shot to be correct.  A prediction of an inflection point in interest rates won’t arise out of an Ouija board; solid logic and data will be used to justify the prediction.  But ultimately, those reasonable justifications could be hiding a different motivation, which is the fame that would accrue from calling the inflection point after multi-decade bull market in bonds.  Because the inflection points are so rare, most careers come and go without the opportunity to predict a sea change, so it is understandable why some would be tempted.

But it is also extremely important to understand that a prediction, or new theory, may change the mainstream narrative but it does not change underlying reality, a consistent theme in this series of articles.  In this case, forecasts of higher GDP growth and inflation don’t make actual GDP and inflation rise, a lesson that should have been learned over the past decade.  Instead, economic events will happily come and go regardless of who or how many financial market observers call for an inflection point in GDP growth, inflation, and interest rates.

Viewed from this perspective, it is easy to envision a scenario in which rise in rates during the first half of 2018 and is followed by yet another lurch lower in the second half of 2018 when the expected rises in GDP growth and inflation do not materialize. Recent fund flow data supports the potential for a change in view (and price/yield), because a record short position has been amassed in bonds, as shown below.

A second explanation for the recent spurt higher in rates is rooted in fundamental analysis.  It is certainly true that budget deficits are rising.  The argument is that increased supply of government bonds will force interest rates higher.  That was the same argument used in the early 1980s when the Reagan tax cuts took effect, yet interest rates continued to fall.  Similar predictions on the inevitability of rising rates were made in the wake of the Bush tax cuts of 2003, yet interest rates continued to fall.  Obviously, larger forces than a supply/demand imbalance were dominant during those periods.

But there is one crucial difference in the economic environment today that didn’t exist in the early 1980s or 2003, as shown below.

In coming months and years, the US government is going to test its ability to issue additional debt in ways it didn’t in the 1980s or 2003, because its debt-to-GDP ratio is greater than 100%, which is 3x what it was in 1980 and roughly 2x what it was in 2003.  Layering even more uncertainty on the supply/demand imbalance is the fact that the Fed is unwinding its massive QE program.  That is, an unparalleled monetary experiment is occurring at the same time as an unprecedented borrowing experiment with a high debt-to-GDP ratio.

So the recent rise in interest rates may not be a market prediction of higher GDP growth and inflation.  Instead, the rise in rates could be a recognition of the unprecedented twin experiments.  If so, we could actually be witnessing the nascent signs of credit risk in the US Treasury market.

Financial textbooks have ruled out the possibility of credit risk embedded into US Treasury yields.  After all, the US Treasury rate is the well-known “risk-free rate” on which all of modern financial theory is grounded.  However, we repeat that the existence of a theory doesn’t change the way the world works in reality.  Sometimes prevailing theories must change, especially when radical changes are afoot, including the existence of the enormous ($50-100 trillion) unfunded liabilities of Medicare and Social Security.  Take another look at the chart of the US debt-to-GDP ratio, and see if the term “credit risk” doesn’t come to mind, even if it will never come to mind while reading a financial textbook.

Further, in another Rinehart and Rogoff study, “This Time Is Different: Eight Centuries of Financial Folly,” sharply rising housing prices and large capital inflows (to finance large trade deficits) tend to occur prior to financial crises.  Those two conditions were present before 2008, and they are present again in 2018.  As the title suggests, the authors also cite the tendency of leading thinkers who fail to learn the lessons of history, and who dismiss serious risks as irrelevant to their era.

Finally, many financial analysts have been perplexed by the anomalies that European sovereign bonds issued by countries such as Portugal, and even European junk bonds, are trading at yields lower than US Treasury bonds.  This is particularly odd given that the US issues bonds denominated in US dollars, the reserve currency, which should require a lower yield.   While it is impossible to state that credit risk is the sole reason for these observed anomalies, these are the types of anomalies you would expect to see if credit risk was beginning to creep into US Treasury prices.

Conclusions

It is possible that the mainstream narrative is correct and that the recent rise in rates is foreshadowing a future of higher GDP growth and inflation.  If so, then markets are discounting a future not yet seen, which is how market sometimes operate.  But sometimes they don’t.  The current levels of GDP growth and inflation are well within their recent ranges, and those recent ranges are lower than they were 10-20 years ago.  More importantly, the underlying problems of high debt levels and aging demographics will continue to constrain the potential for GDP growth and inflation to systematically rise, which are the main reasons that interest rates have persistently declined over the past several decades.  Predicting a regime change to much higher GDP growth, and hence higher inflation, could simply be a case of looking for, and then seeing, something that isn’t there.

Instead, there are two alternative explanations for the recent rise in US Treasury rates.

One is the inevitable temptation of high-profile investors to burnish their professional reputations by “calling the bottom” in rates, which has the power to change the narrative (and prices) in financial markets but it doesn’t have the power to change underlying economic reality.  That is, if high-profile investors put their money where their mouths are, it will affect prices in financial markets, which will affect the perception of other investors, who may tag along with similar strategies.  But there is a short shelf life for that type of process because economic reality will eventually unfold, revealing whether the forecasts of high-profile investors are correct.  As unlikely as it seems now, it is quite possible that they won’t be correct, and that slow GDP growth and low inflation are here to stay awhile longer.  Or, given the length of the tepid economic expansion and high indebtedness, it is even possible that recession arrives prior to the visions of a systematic rise in GDP growth and inflation.  That is one of the implications of the Rinehart and Rogoff study.

Another explanation for rising rates is the emergence of credit risk in US Treasury bonds, the result of the simultaneous and unprecedented experiments of monetary policy (unwind of QE) and fiscal policy (a borrowing binge with a high debt-to-GDP ratio).  The concept of credit risk in US Treasury prices is outlawed in financial theory.  But other aspects of today’s financial landscape, such as negative interest rates or European junk bonds trading at lower yields than US Treasury bonds, also weren’t supposed to occur and cannot be explained by orthodox financial theories.  Theories can change how we observe facts, but they can’t change the facts.

QE: Can a New Theory Change Reality?

“Peter B. Cook is the author of the ‘Is That True?’ series of articles, which help explain the many statements and theories circulating in the mainstream financial media often presented as “truths.” The motives and psychology of market participants, which drives the difference between truth and partial-truth, are explored.”

During a week of obsession with volatility products, it might seem odd to return to the well-worn topic of Quantitative Easing (QE).  But a common thread runs through the spectacular implosion of short volatility strategies and QE; they both are strictly financial-market phenomena.

That is, one shouldn’t assume that a move in financial markets, even an extremely large one, is caused by events in the real economy, where people are taking orders for widgets, producing widgets, delivering widgets, or even writing financial analyses.

Similarly, one shouldn’t assume that a move in financial markets causes events to occur in the real economy.  As data will show in the following pages, this logic applies even to the trillions of dollars spent on global QE, the largest monetary experiment in history.

QE is the program concocted and used by central banks to intervene in financial markets to purchase bonds and stocks, in hopes that both will rise in value.  Officially, central banks have publicly disclosed QE purchases of government bonds, mortgage-backed securities (MBS), investment grade bonds, junk bonds, equities, and ETFs composed of equities.

The combined activities of the major central banks are detailed in the now-familiar graphs of cumulative activity……

…..and annual activity.

If the forecasts are correct, the peak in the cumulative amount of QE purchases will occur later in 2018 (top graph), after a remarkable decade of peak central bank experimentation, featuring a 6x rise in holdings of securities.  Meanwhile, the peak in annual activity has already occurred during Q1 2017 (bottom graph), at a rate of almost $200 billion per month, or $2+ trillion per year.  The Federal Reserve (Fed) has begun to sell its portfolio of securities, but the selling is minuscule compared to current buying of the European Central Bank (ECB) and the Bank of Japan (BOJ.)  That said, the pace of all QE purchases has been in rapid decline, and are forecasted to accelerate to the downside until QE finally ends in 2019.

In theory, the father of modern-day QE, Ben Bernanke, would tell us that QE purchases cause an increase in stock and bond prices all over the globe, making people feel wealthy, inducing them to spend more than they otherwise would, and leading to greater GDP growth than would otherwise have occurred.  This is Bernanke’s “Wealth Effect” theory in a nutshell.  As a side bonus, inflation would theoretically rise.  But did any of these promised theoretical effects actually happen?

By looking at the data, we now know that during successive rounds of QE in the US:

  1. Changes in QE purchases probably affected US bond prices, but in the opposite direction of expectations
  2. Changes in QE purchases probably affected US stock prices, and in the expected direction
  3. Changes in QE purchases probably had no effect on changes in US GDP growth
  4. Changes in QE purchases probably had little effect on changes in US inflation

  1. Changes in QE Purchases Probably Affected Bond Prices, But in the Opposite Direction of Expectations

There is no need for fancy statistics when a quick glance at the chart below tells you all you need to know.  In contrast to the QE theory of central bankers, during the periods of Fed QE programs, interest rates rose, and bond prices fell.    During 2014, when the Fed reduced its QE purchases (the so-called “taper”), bond yields fell, and bond prices rose, making a final low in early 2016.  One possible explanation for the rise in rates during QE is that investors believed QE programs would succeed in generating GDP growth and inflation, thereby reducing the value of bonds.  Similarly, when QE was suspended, investors appear to have believed that deflation and slow growth would persist, thereby increasing the value of bonds.

Data Courtesy: St. Louis Federal Reserve (FRED)

Modern markets are interconnected because investors can quickly change positions via liquid foreign exchange markets and access to global leverage via large financial institutions.  Therefore, large QE programs in one country affect asset prices in other countries.  Carefully reviewing the previous chart of global central bank QE purchases, you can see a radical jump in QE purchases by the ECB and BOJ which coincided with the spike in US interest rates during 1H 2016.   The continued $2 trillion of annual purchases by the ECB and BOJ appear to explain the latest leg up in US interest rates to multi-year highs.

In summary, bond yields rose during each of the several periods of QE acceleration, suggesting that QE activities were responsible for rising interest rates, which is the opposite of what a simple analysis of supply and demand would have predicted.

 

  1. Changes in QE Purchases Probably Affected Stock Prices, and in the Expected Direction

In the graph below, there are three main periods in which QE purchases accelerated rapidly and persisted for at least one year; in 2009, early 2013, and late 2015.

The chart below shows the year-over-year rate of change of the S&P 500 index.  The S&P 500 index experienced 20+% gains in 2009, 2013, and 2016-17, which matches the periods in which QE purchases accelerated and persisted.  So, while it is impossible to make a statement that changes in QE purchases caused a rise in stock prices, at least the data is consistent with such a statement.

The chart below is another way of presenting the relationship between QE and stock prices in the US.  The line shaded black and green shows the S&P 500 index over the past ten years.  The green shading occurred during QE periods, which are also shown by the increases in the Fed’s balance sheet.

The one outlier in the chart has occurred since late 2016 when stock prices leaped while the Fed’s QE program was suspended.  Just as was the case with bonds, we suspect that the acceleration of QE by the BOJ and ECB is at least partly responsible for the rise in US stock prices, as excess money sloshes around the globe.

Data Courtesy: St. Louis Federal Reserve (FRED)

In summary, the data makes a strong case that QE programs succeeded in boosting stock prices.

Considering that periods of accelerated and sustained QE purchases are associated with lower bond prices and higher stock prices, then it appears that overall, investors sold bonds to central banks and replaced their bond investments with stock market investments.  If so, then central bank QE programs sponsored an enormous rotation out of bonds and into stocks.  But that’s not the intended result of the wealth effect theory, which is higher bond AND stock prices.

In addition, intentionally boosting stock prices could produce unintended negative consequences that we have not yet seen.  For example, one way to look at QE is as a suppressant of volatility in financial markets, a policy that has been running for almost a decade.  The public seems to have caught on, given the popularity of selling volatility to produce “income.”  As is the case in many strategies over time that claim to produce higher income than is normally available, this type of strategy is actually transforming future capital losses into current income.

Looking forward, given that periods of accelerated and sustained QE purchases produced noticeable changes in stock and bond prices, it becomes clear why the Fed is moving slowly as it unwinds QE.  In fact, one member of the Fed leadership stated that watching QE unwind would be as boring as watching paint dry.   That statement might be more a hope than a forecast, given that a full cycle of QE (i.e., QE and its unwind) has never before been attempted.  So there is no data from the past that could support a forecast of drying paint, or for that matter, any particular forecast.

 

  1. Changes in QE Purchases Probably Had No Effect on Changes in GDP Growth

In theory, if QE worked as planned, GDP growth should have shown some relationship to changes in QE purchases.  But in fact, it didn’t.  The chart below is a regression of changes in QE purchases to changes in US GDP growth.  If a strong relationship between GDP growth and changes in QE purchases existed, the dotted line would have a meaningful slope and tight cluster of data around it.

However, the dotted line is almost horizontal, and the data points appear randomly scattered, showing that changes in GDP growth occurred independently of changes in QE purchases. In fact, the average GDP growth rate when Fed assets were not growing is in a very similar range as the range of GDP growth when they were ballooning their assets at double-digit rates.  Statistically, the insignificant R-squared of .0426 further confirms this idea.

Data Courtesy: St. Louis Federal Reserve (FRED)

  1. Changes in QE Purchases Probably Had Little Effect on Changes in Inflation

The chart below is a regression of changes in QE purchases and changes in CPI inflation, which shows a weak association between the changes in QE and CPI. Just as was the case with GDP growth, the range of CPI when the Fed was not growing their balance sheet was a similar range as to when it was expanding its balance sheet.  The dotted line has a low slope, and the R-squared is .0855 meaning it’s hard to draw a statistical conclusion that changes in QE caused changes in CPI.

Data Courtesy: St. Louis Federal Reserve (FRED)

 “All Else Held Constant”

Over the QE Era (2009-current), a variety of large factors other than QE purchases weighed on or supported the global GDP and inflation results.  For example, during 2011 Europe went through an existential crisis due to over-indebtedness of its smaller members.  Also, US government deficits varied throughout the period.  Finally, Chinese credit growth spiked dramatically higher, beginning in early 2016.    For these reasons, it is difficult to isolate the effect of any one variable (such as QE programs) on economic statistics such as GDP or inflation.  That is, all else is never held constant in the real world, which makes economics a study in human behavior and not a science.

With that caveat in mind, the preceding data and analysis do not attempt to make a precise statement that QE purchases “caused” anything, although there is evidence that QE coincided with rising yields and stock prices.  That’s because QE has been a direct intervention into financial markets.

In contrast, QE can only indirectly intervene into the real economy, so if QE were successful, the data would show an association between QE and upward changes to GDP growth and inflation.  But the data doesn’t show any association.  That’s why statements by high-profile economists are suspect when they assert that QE programs “caused” a rise in GDP growth or inflation.

Looking forward, as difficult as it is to envision right now, it is possible that the unwind of QE will produce results in financial markets running in the opposite direction of QE.  If so, then over coming months, we should expect lower stock prices, plus the counter-intuitive result of lower bond yields.  Also, since QE was a market event and not an economic event, the unwind of QE should produce similar results as QE did, which is very little impact on inflation or GDP growth.

Conclusions

In contrast to the theory that QE purchases would lift bond and stock prices, GDP growth, and inflation, the QE Era shows that increases in QE purchases were associated with declines in bond prices (i.e., higher yields) and higher stock prices.  However, the data shows that QE had little or no effect on GDP growth and YOY% inflation.     

In summary, for financial markets, where QE purchases have a direct impact, central banks were probably 1 for 2 in their goals of lifting US bond and stock prices in pursuit of the wealth effect.

For the economy, where QE purchases can only have an indirect impact, central banks were probably 0 for 2 in their stated goals of increasing GDP growth and inflation.

Taken together, a record of 1 for 4 for hitting goals is not convincing evidence that trillions of dollars QE produced its desired result.  Put simply, the creation of a new theory doesn’t change the way things actually happen in the real world.

COTD – The Pin That Pricks The Bubble

Over the past 18-months or so, I have written several articles on the potential for a “market melt-up,” which I updated in last week’s post “Market Bulls Target S&P 3000.” 

“With investors now betting on a sharp rise in earnings to reduce the current levels of overvaluation, there seems to be little in the way of the next major milestones for 30,000 on the Dow and 3000 on the S&P 500.”

Note: For more on earnings and expectations read this past weekend’s newsletter.

I made the point specifically that “bull-runs” are a one-way trip. 

Throughout history, overbought, excessively extended, overly optimistic bull markets have NEVER ended by going “sideways.”

Not surprisingly that article elicited quite a few emails and comments asking “what would be the ‘pin’ that pricks the current bubble.”

The true answer is I don’t know exactly what the catalyst will be.

 

However, while much of the media is currently suggesting that interest rates are about to surge higher due to economic growth and inflationary pressure, I disagree.

Economic growth is “governed” by the level of debt and deficits as I discussed this past weekend. Tax cuts only make that problem worse in the long-term. But as shown above, it isn’t JUST the government that is heavily leveraged – it is every single facet of the economy.

Debt has exploded.

(The chart below shows the combined totals of Government, Corporate, Household,  Margin and Bank debt – in BILLIONS.)

Which leads us to our chart of the day.

Chart Of The Day (COTD)

Each time rates have “spiked” in the past it has generally preceded a mild to severe market correction.

However, when the economy is as heavily leveraged as it is today, higher borrowing costs rapidly slow economic growth as rising interest burdens divert capital from consumption. As I laid out previously, interest rates impact everything.

1) The Federal Reserve has been buying bonds for the last 9- years in an attempt to push interest rates lower to support the economy. The recovery in economic growth is still dependent on massive levels of domestic and global interventions. Sharply rising rates will immediately curtail that growth as rising borrowing costs slows consumption.

2) The Federal Reserve currently runs the world’s largest hedge fund with over $4 Trillion in assets. Long Term Capital Mgmt. which managed only $100 billion at the time nearly brought the economy to its knees when rising interest rates caused it to collapse. The Fed is 45x that size.

3) Rising interest rates will immediately kill the housing market, not to mention the loss of the mortgage interest deduction if the GOP tax bill passes, taking that small contribution to the economy away. People buy payments, not houses, and rising rates mean higher payments.

4) An increase in interest rates means higher borrowing costs which lead to lower profit margins for corporations. This will negatively impact the stock market given that a bulk of the “share buybacks” have been completed through the issuance of debt.

5) One of the main arguments of stock bulls over the last 9-years has been the stocks are cheap based on low interest rates. When rates rise the market becomes overvalued very quickly.

6) The massive derivatives market will be negatively impacted leading to another potential credit crisis as interest rate spread derivatives go bust.

7) As rates increase so does the variable rate interest payments on credit cards.  With the consumer are being impacted by stagnant wages, higher credit card payments will lead to a rapid contraction in income and rising defaults. (Which are already happening as we speak)

8) Rising defaults on debt service will negatively impact banks which are still not adequately capitalized and still burdened by large levels of bad debts.

9) Commodities, which are very sensitive to the direction and strength of the global economy, will plunge in price as recession sets in.

10) The deficit/GDP ratio will begin to soar as borrowing costs rise sharply. The many forecasts for lower future deficits will crumble as new forecasts begin to propel higher.

I could go on but you get the idea.”

Since interest rates affect “payments,” increases in rates quickly have negative impacts on consumption, housing, and investment which ultimately deters economic growth.

With “expectations” currently “off the charts,” literally, it will ultimately be the level of interest rates which triggers some “credit event” that starts the “great unwinding.”  

It has happened every time in history.

Given the current demographics, debt, pension and valuation headwinds, ten-year rates much above 2.6% are going to start to trigger an economic decoupling. Defaults and delinquencies are already on the rise and higher rates will only lead to an acceleration.

The problem with most of the forecasts for the end of the bond bubble is the assumption that we are only talking about the isolated case of a shifting of asset classes between stocks and bonds. However, the issue of rising borrowing costs spreads through the entire financial ecosystem like a virus. The rise and fall of stock prices have very little to do with the average American and their participation in the domestic economy.

Interest rates, however, are an entirely different matter.

Could rates go higher from here first? Absolutely.

But bonds will likely once again spend another decade, or so, outperforming stocks.

Is It True? Do Low Rates Justify High Valuations

“Peter B. Cook is the author of the ‘Is That True?’ series of articles, which help explain the many statements and theories circulating in the mainstream financial media often presented as “truths.” The motives and psychology of market participants, which drives the difference between truth and partial-truth, are explored.”

When the financial media continuously repeat an opinion as fact, it spawns a mainstream narrative, which produces a powerful effect on investor psychology. One mainstream narrative, repeated with certainty, is low interest rates cause high stock market valuations, which is supported by the public statements of investment luminaries such as Warren Buffett.

A related mainstream truth is rising rates will cause high stock market valuations to fall. In fact, recently, both Bill Gross and Jeffrey Gundlach have commented on the level of 10-year Treasury rates and why they are destined to go higher. Gundlach even went further, suggesting that if 10-year rates were to rise above 2.63% (currently 2.55%), stock prices would begin to fall.  While Gundlach possesses a sterling track record, and his comment captures a prominent fear among investors, his comment also seems to define the term “spurious precision.” Can it be true that stocks are a safe investment at 2.62% but not 2.63%?

Are the two “truths” in bold above supported by the historical record? Believe it or not, the answer is no, as we will explain.

Let’s begin by examining stock market valuations. Most professional observers of financial markets would agree that stocks valuations are high compared to their historical range. This fact is demonstrated in the chart of the Shiller CAPE ratio (Cyclically-Adjusted PE ratio) below.

Source:  Robert Shiller, multipl.com.  Data through January 9, 2018.

While no single statistic perfectly describes reality, the CAPE ratio highlights how cheap or expensive the stock market is relative to its historical average. Indeed, comparing the current CAPE ratio of 33.38 to its median value of 16.15, stocks would have to fall by more than 50% to be in line with historical norms.

The CAPE chart is more than a historical chart of valuation. It is also a chart of investor psychology compared to historical norms, because the chart measures the investing public’s fear or mania to “buy” a dollar’s worth of stock market earnings at any point in time. For example, a long bull market began in August 1982, when stocks were cheap (CAPE = 7) based on the fearful consensus reasoning of the day. The subsequent 18-year rally mushroomed into the internet stock craze that peaked in March 2000, when stocks were expensive (CAPE = 45), based on manic consensus reasoning of the day.

Excluding the tech mania of 2000, today stocks are more highly-valued than at any other time during the past 140 years, even including the peak at the end of the Roaring 1920s. If high valuations are a sign of investor psychology, then investors today are about as optimistic as at any time in the past.  Put another way, today’s high valuations indicate that investors see more future upside (reward) than future downside (risk).

The psychological effect on stock prices can also be seen in the chart below, which breaks down the PE ratio into P (price) and E (earnings). When the gap between price (blue line) and earnings (green line) is high, investors are willing to pay high a price to buy a dollar of earnings.  A glance at the chart shows the same eras of peak valuations occurring in the 1920s, the 1960s, and again over the past two decades. Most recently, during the past few years earnings have been flat while stocks were rising dramatically. While bidding up stock prices during this period, it appears investors were expecting a big jump in earnings. If so, they didn’t receive what they expected.  So, if earnings didn’t drive stock prices higher, what did? The inquiring minds of the financial punditry need another narrative.

Source:  Robert Shiller, multipl.com.  Data through June 2017

Regardless of the common sense embedded in the CAPE chart, doubters of the CAPE methodology would probably make arguments driven by “relative value,” not “absolute value.” Relative value arguments state that one asset is valued at price X because another asset is valued at price Y.

Let’s substitute stocks for price X and interest rates as price Y. When interest rates (Y) are extremely low, it makes intuitive sense that stock prices (X) would be high, because interest rates are a main theoretical factor in the valuation of stocks. Another sensible argument is that prevailing interest rates provide competition for an investor’s dollar relative to an investment in the stock market. For these reasons, when rates (Y) are low, stocks (X) are perceived to be more attractive, relatively.

Indeed, the two charts presented so far only show the relationship between the price of stocks and the earnings of the underlying companies; the charts say nothing about the level of interest rates.  Interest rates are the crucial input into the theoretical valuation of stocks. In addition, interest rates are thought to drive the prices of all other assets such as real estate, privately operated businesses, commodities, and currencies.

To analyze the relative value argument, let’s look at the interaction of interest rates and stock valuations over the broad sweep of time. As shown below, extremely high stock market valuations occurred in 1929, 2000, and recently. But interest rates were extremely low only once (recently) during those three occurrences. If low interest rates coincide with extremely high stock valuations only one time out of three, then it is obvious that low interest rates cannot cause high stock valuations. Yet “low interest rates cause high stock valuations” is one of the certainties of the current mainstream narrative.

Source:  Robert Shiller, multipl.com.  Data through June 2017.

Isolating the times when interest rates were extremely low, that has occurred twice; in the 1940s and again in recent times. But in the 1940s, stock valuations were low. So, the statement that low interest rates cause high stock valuations is supported by a .500 batting average in the historical record, which is the equivalent of a coin-flip.

A better batting average is achieved by the relative value argument that extremely high interest rates coincide with extremely low stock market valuations, which occurred in 1921 and 1981.  Although a sample size of two observations is not enough from which to draw a statistically-significant conclusion, at least the batting average is 1.000.

Summarizing the historical relationship between extremes in stock market valuations with extremes in interest rates:

  • Extremely high interest rates, which have occurred twice, coincided with low stock market valuations. This fact does not prove that high interest rates “cause” low stock valuations. But at least the historical record is consistent with such a statement.
  • Extremely low interest rates, which have occurred twice, have coincided with high stock market valuations only once; today. The historical record (1/2 probability) does not validate the highly-confident mainstream narrative that low interest rates “cause” or extremely high stock market valuations.
  • Extremely high stock valuations have occurred three times. Only once (1/3 probability) did high stock valuations coincide with low interest rates; today.
  • If extremely low interest rates do not cause extremely high stock market valuations, then a rise in rates should not necessarily cause a decline in stocks. That is, the historical record does not support the near-certain mainstream narrative that a rise in rates will torpedo stock prices.
  • To demonstrate the ability of a consensus narrative to overwhelm analysis of historical facts and even current reality, consider that the Fed has hiked short-term interest rates five times since December 2015. Also, long-term rates bottomed in mid-2016 and have moved more than a full percent higher. Yet the S&P 500 index has risen more than 30% since the lows in short-term and long-term rates. 

Beware the investment advisor, pundit, or superstar investor who is certain that extremely low rates cause extremely high stock valuations, or that a rise in rates from extremely low levels will cause a decline in stock prices. Stocks may fall, and interest rates may rise, but the historical record disagrees that one causes the other.

RIA Chart Book: Q4-2017 Most Important Charts

In Q3 of last year, Michael Lebowitz and I decided that each quarter we would produce a “chartbook” of the “most important charts” from the last quarter for you to review.

In addition to the graphs, we provided a short excerpt from the article as well as the links to the original articles for further clarification and context if needed. We hope you find them useful, insightful, and importantly we hope they give you a taste of our unique brand of analysis. In most cases, the graphs, data, and commentary we provide are different from that of the business media and Wall Street.  Simply put, our analysis provides investors an edge that few are privy to.


The Federal Reserve Reveals The Ugly Truth

The 2016 survey confirms statements I have made previously regarding the Fed’s monetary interventions leaving the majority of Americans behind:

However, setting aside that point for the moment, how valid is the argument the rise of asset prices is related to economic strength. Since companies ultimately derive their revenue from consumers buying their goods, products, and services, it is logical that throughout history stock price appreciation, over the long-term, has roughly equated to economic growth. However, unlike economic growth, asset prices are psychologically driven which leads to “boom and busts” over time. Looking at the current economic backdrop as compared to asset prices we find a very large disconnect.

Since Jan 1st of 2009, through the end of June, the stock market has risen by an astounding 130.51%. However, if we measure from the March 9, 2009 lows, the percentage gain explodes to more than 200%. With such a large gain in the financial markets we should see a commensurate indication of economic growth – right?”

“The reality is that after 3-massive and unprecedented Federal Reserve driven “Quantitative Easing” programs, a maturity extension program, bailouts of TARP, TGLP, TGLF, etc., HAMP, HARP, direct bailouts of Bear Stearns, AIG, GM, bank supports, etc., all of which total more than $33 Trillion, the economy grew by just $2.64 Trillion, or a whopping 16.7% since the beginning of 2009. The ROI equates to $12.50 of interventions for every $1 of economic growth.

Read: Fed Study: The Bottom 90% And The Failure Of Prosperity


Risk vs. Reward

There are two divergent facts that make investing in today’s market extremely difficult.

  1. The market trend by every measure is clearly bullish. Any novice technician with a ruler projected at 45 degrees can see the trend and extrapolate ad infinitum.
  2. Markets are extremely overvalued. Intellectually honest market analysts know that returns produced in valuation circumstances like those observed today have always been short-lived when the inevitable correction finally arrives.

In The Deck is Stacked we presented a graph that showed expected five-year average returns and the maximum drawdowns corresponding with varying levels of Cyclically-Adjusted Price-to-Earnings (CAPE) ratios since 1958. We alter the aforementioned graph, as shown below, to incorporate the odds of a 20% drawdown occurring within the next five years.

Over the next five years we should expect the following:

  1. Annualized returns of -.34% (green line)
  2. A drawdown of 27.10% from current levels (red line)
  3. 76% odds of a 20% or greater correction (yellow bars)

Read: Protecting Your Blind Side


Tax Cut Impact

So, with 80% of Americans living paycheck-to-paycheck, the need to supplant debt to maintain the standard of living has led to interest payments consuming a bulk of actual disposable income. The chart below shows that debt has exceeded personal consumption expenditures. Therefore, any tax relief will most likely evaporate into the maintaining the current cost of living and debt service which will have an extremely limited, if any, impact on fostering a higher level of consumption in the economy.

Read: Bull Trap – The False Promise Of Tax Cuts


One Chart

Our chart of the day is a long-term view of price measures of the market. The S&P 500 is derived from Dr. Robert Shiller’s inflation adjusted price data and is plotted on a QUARTERLY basis. From that quarterly data I have calculated:

  • The 12-period (3-year) Relative Strength Index (RSI),
  • Bollinger Bands (2 and 3 standard deviations of the 3-year average),
  • CAPE Ratio, and;
  • The percentage deviation above and below the 3-year moving average. 
  • The vertical RED lines denote points where all measures have aligned

Read: One Chart Show Why Investors Are Dealt A Losing Hand


Borrowing From The Future

The stock market has returned more than 60% since 2007 peak, which is more than three times the growth in corporate sales growth and 30% more than GDP. The all-time highs in the stock market have been driven by the $4.5 trillion increase in the Fed’s balance sheet, hundreds of billions in stock buybacks, PE expansion, and ZIRP.

It is critical to remember the stock market is NOT the economy. The stock market should be reflective of underlying economic growth which drives actual revenue growth. Furthermore, GDP growth and stock returns are not highly correlated. In fact, some analysis suggests that they are negatively correlated and perhaps fairly strongly so (-0.40).

However, in the meantime, the promise of a continued bull market is very enticing as the “fear of missing out” overrides the “fear of loss.”

Read: Bogle, Buffett, Shiller, Tobin – Valuations Are Expensive


Markets Don’t Compound

Morgan Stanley states that in 30-years if the Dow grows at just 5% annually, it will hit 500,000. However, if the Dow actually compounded returns at 5%, in the future, as Morgan suggests, it would have done so in the past and would ALREADY be at 500,000. 

But it’s not. We are just stuck here at a crappy ole’ 23,000.

There is a huge difference between compound returns and average returns. The historical return of the markets since 1900, including dividends, has averaged a much higher rate of return than just 5% annually. Therefore, the Dow should actually be much closer to 1,000,000 than just 500,000.

Read: Dow 500,000? We Are Already There


Not In A New Secular Bull Market

However, as noted above, and as shown below, “secular bull markets,” which are long-term growth trends, have never started from 15x valuations and immediately surged to the second highest level on record. Historically, as shown below, secular bull markets are born of excessive pessimism and low valuations that stay in place for years as earnings and profitability grow faster than prices (keeping valuations lower.) Despite Mr. Saut’s hopes, that is simply not the case today as valuations exploded as earnings, economic and profit growth lagged the liquidity induced surge in asset prices.

Read: Fundamentally Speaking – Markets Being Driven By Fundamentals?


The Myths Of Tax Cuts

Myth #1: Tax Cuts Will Create An Economic Revival

As the Committee for a Responsible Federal Budget stated last week:

“Tax cuts do not pay for themselves; they can create growth, but in the amount of tenths of percentage points, not whole percentage points. And they certainly cannot fill in trillions in lost revenue. Relying on growth projections that no independent forecaster says will happen isn’t the way to do tax reform.”

That is absolutely correct and as I pointed out on Friday:

“As the chart below shows there is ZERO evidence that tax cuts lead to stronger sustained rates of economic growth. The chart compares the highest tax rate levels to 5-year average GDP growth. Since Reagan passed tax reform, average economic growth rates have only gone in one direction.”

Read: The 3-Myths Of Tax Cuts


What does 2028 hold in store?

The following graph and table explore the range of outcomes that are possible given the scenarios outlined above. To help put context around the wide range of expected returns, we calculated an equity-equivalent price of the 10-year U.S. Treasury Note and added it to the graph as a black dotted line. Investors can use the line to weigh the risk and rewards of the S&P 500 versus the option to purchase a relatively risk-free U.S. Treasury Note. The table below the graph serves as a legend and reveals more information about the forecasts. The color shading on the table affords a sense of whether the respective scenario will produce a positive or negative return as compared to the U.S. Treasury Note. The far right column on the table indicates the percentage of observations since 1881 that CAPE has been higher than the respective scenarios.

Data Courtesy: Robert Shiller and 720Global/Real Investment Advice

Read: Three Easy Pieces


Why Rates Can’t Rise

The chart below shows only the composite index and the 10-year Treasury rate. Not surprisingly, the recent decline in the composite index also coincides with a decline in interest rates.

In the current economic environment, the need for capital remains low, outside of what is needed to absorb incremental demand increases caused by population growth, as demand remains weak. While employment has increased since the recessionary lows, much of that increase has been the absorption of increased population levels.

Read: Bond Bears & Why Rates Won’t Rise


On Punditry

So sorry, Suze. This bit of knowledge? Strikeout. Not everything compounds.

“Orman explained that if a 25-year-old puts $100 into a Roth IRA each month, they could have $1 million by retirement.” 

This statement perplexes me. While I wholeheartedly agree with a monthly investing or saving discipline spouted here, especially into a Roth IRA where earnings grow tax-deferred and withdrawn tax-free at retirement, I had a dilemma making her retirement numbers work.

As outlined in the chart above, on an inflation-adjusted basis, achieving a million-buck balance in 40 years by dollar-cost averaging $100 a month, requires a surreal 11.25% annual return. In the real world (not the superstar pundit realm), a blind follower of Suze’s advice would experience a whopping retirement funding gap of $695,254.68.

I don’t know about you, to me, this is a Grand Canyon expectation vs. reality-sized unwelcomed surprise.

Read: Fabrications Of Financial Media Superstars


The Myth Of Buy & Hold

Once you set aside the daily media chatter, sales pitches, poor investment advice and investing methods that have a complete lack of evidence to support them, you find out one simple truth:

“Managing the risk of drawdowns is what separates having enough money to live out your retirement dreams, or not.”

With this in mind, the reality of saving for your retirement should be clear as 2 of the 3 methods discussed above leave you well short of your financial goals.

Read: 2-Of-3 Investing Methods Will Leave You Short


Global QE

Global central banks’ post-financial crisis monetary policies have collectively been more aggressive than anything witnessed in modern financial history. Over the last ten years, the six largest central banks have printed unprecedented amounts of money to purchase approximately $14 trillion of financial assets as shown below. Before the financial crisis of 2008, the only central bank printing money of any consequence was the Peoples Bank of China (PBoC).

The central banks’ goals, in general, are threefold:

  • Expand the money supply allowing for the further proliferation of debt, which has sadly become the lifeline of most developed economies.
  • Drive financial asset prices higher to create a wealth effect. This myth is premised on the belief that higher financial asset prices result in greater economic growth as wealth is spread to the masses.
    • “And higher stock prices will boost consumer wealth and help increase confidence, which can also spur spending. Increased spending will lead to higher incomes and profits that, in a virtuous circle, will further support economic expansion.”– Ben Bernanke Editorial Washington Post 11/4/2010.
  • Lastly, generate inflation, to help lessen the burden of debt.

Read: A Question For Every Investor


Turning Japanese

More importantly, while there are many calling for an end of the “Great Bond Bull Market,” this is unlikely the case. As shown in the chart below, interest rates are relative globally. Rates can’t rise in one country while a majority of economies are pushing negative rates. As has been the case over the last 30-years, so goes Japan, so goes the U.S.

Unfortunately, for the Administration, the reality is that cutting taxes, and MORE debt, is unlikely to change the outcome in the U.S. The reason is that monetary interventions and government spending don’t create organic, and sustainable, economic growth. Simply pulling forward future consumption through monetary policy continues to leave an ever-growing void in the future that must be filled. Eventually, the void will be too great to fill.

Read: Tax Reform And The Japanification Of America


The Long End Of The Curve

Each time, when liquidity was extracted from the financial markets, the rotations from “risk” to “safety” pushed yields lower. Not higher. The chart below is the 8-rolling average of the Fed’s balance sheet which more clearly shows the correlation.

The correlation makes complete sense when you think about it. When the Fed is expanding their balance sheet, money flows into the equity markets driving “risk” assets higher. With the reduced need for “safety,” money rotates from bonds into stocks on an asset allocation basis. The opposite occurs when the Fed extracts liquidity from the markets.

Read: Can The Fed Really Boost Bond Yields


These are some of our favorite charts and we hope you find them useful and insightful. Please send us any comments, suggestions, or your favorite charts to us for consideration.

Tax Reform & The “Japanification” Of America

On Friday, Kevin Brady of the House Ways and Means Committee was on my radio program discussing the “Tax Cuts & Jobs Act” bill which was released later in the day.

Here are the details of the release he referenced in the interview.

Of course, the real question is how are you going to “pay for it?”

Even as Kevin Brady noted in our interview, when I discussed the “fiscal” side of the tax reform bill, without achieving accelerated rates of economic growth – “the debt will balloon.”

The reality, of course, is that is exactly what will happen because there is absolutely NO historical evidence that cutting taxes, without offsetting cuts to spending, leads to stronger economic growth.

Those, of course, are the long-term concerns that will lead to lower rates of returns for equity-based investors and will continue to suppress interest rates for the next decade as the “Japanification” of the U.S. continues.

Let’s Be Like Japan

“Bad debt is the root of the crisis. Fiscal stimulus may help economies for a couple of years but once the ‘painkilling’ effect wears off, U.S. and European economies will plunge back into crisis. The crisis won’t be over until the nonperforming assets are off the balance sheets of US and European banks.”Keiichiro Kobayashi, 2010

While Kobayashi will ultimately be right, what he never envisioned was the extent to which Central Banks globally would be willing to go. As my partner Michael Lebowitz pointed out last week:

“Global central banks’ post-financial crisis monetary policies have collectively been more aggressive than anything witnessed in modern financial history. Over the last ten years, the six largest central banks have printed unprecedented amounts of money to purchase approximately $14 trillion of financial assets as shown below. Before the financial crisis of 2008, the only central bank printing money of any consequence was the Peoples Bank of China (PBoC).”

As he noted, the belief was that by driving asset prices higher, economic growth would follow. Unfortunately, this has yet to be the case as debt both globally and specifically in the U.S. has exploded.

“QE has forced interest rates downward and lowered interest expenses for all debtors. Simultaneously, it boosted the amount of outstanding debt. The net effect is that the global debt burden has grown on a nominal basis and as a percentage of economic growth since 2008. The debt burden has become even more burdensome.”

While Mr. Brady is very optimistic about future rates of economic growth, even Ms. Yellen in her latest policy announcement was not so sure. The Fed’s average of long-term growth expectations is currently running at just 1.9%.

The continuing mounting of debt from both the public and private sector, combined with rising health care costs, particularly for aging “baby boomers,” are among the factors behind soaring US debt. While “tax reform,” in a “vacuum”  should boost rates of consumption and, ultimately, economic growth, the economic drag of poor demographics and soaring costs, will offset any of the benefits.

The complexity of the current environment implies years of sub-par economic growth ahead as noted by the Fed last week. Of course, the US is not the only country facing such a gloomy outlook for public finances, but the current economic overlay displays compelling similarities with Japan in the 1990s.

Also, while it is believed that “tax reform” will fix the problem of lackluster wage growth, create more jobs, and boost economic prosperity, one should at least question the logic given that more expansive spending, as represented in the chart above by the surge in debt, is having no substantial impact on economic growth. As I have written previously, debt is a retardant to organic economic growth as it diverts dollars from productive investment to debt service.

Of course, one only needs to look at Japan for an understanding that QE, low-interest rate policies and expansion of debt have done little economically. Take a look at the chart below which shows the expansion of the BOJ assets versus growth of GDP and levels of interest rates.

Notice that since 1998, Japan has not achieved a 2% rate of economic growth. Even with interest rates now pushing into negative territory, economic growth remains mired below one-percent, providing little evidence to support the idea that inflating asset prices by buying assets leads to stronger economic outcomes.

But yet, the current Administration believes our outcome will be different.

The reality is that the U.S. is now caught in the same liquidity trap as Japan. With the current economic recovery already pushing the long end of the economic cycle, the risk is rising that the next economic downturn is closer than not. The danger is that the Federal Reserve is now potentially trapped with an inability to use monetary policy tools to offset the next economic decline when it occurs.

This is the same problem that Japan has wrestled with for the last 20 years. While Japan has entered into an unprecedented stimulus program (on a relative basis twice as large as the U.S. on an economy 1/3 the size) there is no guarantee that such a program will result in the desired effect of pulling the Japanese economy out of its 30-year deflationary cycle. The problems that face Japan are similar to what we are currently witnessing in the U.S.:

  • A decline in savings rates to extremely low levels which depletes productive investments
  • An aging demographic that is top heavy and drawing on social benefits at an advancing rate.
  • A heavily indebted economy with debt/GDP ratios above 100%.
  • A decline in exports due to a weak global economic environment.
  • Slowing domestic economic growth rates.
  • An underemployed younger demographic.
  • An inelastic supply-demand curve
  • Weak industrial production
  • Dependence on productivity increases to offset reduced employment

The lynchpin to Japan, and the U.S., remains demographics and interest rates. As the aging population grows becoming a net drag on “savings,” the dependency on the “social welfare net” will continue to expand. The “pension problem” is only the tip of the iceberg.

If interest rates rise sharply it is effectively “game over” as borrowing costs surge, deficits balloon, housing falls, revenues weaken and consumer demand wanes. It is the worst thing that can happen to an economy that is currently remaining on life support.

Japan, like the U.S., is caught in an on-going “liquidity trap”  where maintaining ultra-low interest rates are the key to sustaining an economic pulse. The unintended consequence of such actions, as we are witnessing in the U.S. currently, is the ongoing battle with deflationary pressures. The lower interest rates go – the less economic return that can be generated. An ultra-low interest rate environment, contrary to mainstream thought, has a negative impact on making productive investments and risk begins to outweigh the potential return.

More importantly, while there are many calling for an end of the “Great Bond Bull Market,” this is unlikely the case. As shown in the chart below, interest rates are relative globally. Rates can’t rise in one country while a majority of economies are pushing negative rates. As has been the case over the last 30-years, so goes Japan, so goes the U.S.

Unfortunately, for the Administration, the reality is that cutting taxes, and MORE debt, is unlikely to change the outcome in the U.S. The reason is that monetary interventions and government spending don’t create organic, and sustainable, economic growth. Simply pulling forward future consumption through monetary policy continues to leave an ever-growing void in the future that must be filled. Eventually, the void will be too great to fill.

But hey, let’s just keep doing the same thing over and over again, which hasn’t worked for anyone as of yet, hoping for a different result. 

What’s the worst that could happen?  

Why $19 Trillion In Debt IS A Problem

According to the World Economic Forum, the United States has achieved a new TOP 10 ranking. Tell us what we’ve won Bob:

“Coming in at #10 – the United States, at 104%, gets nothing but the privilege of being on the list of countries with the highest debt/GDP ratios.”

So…it’s just $19 Trillion? A mere doubling of the national debt in eight years isn’t really a problem, right? According to Bob Bryan at Business Insider, that answer is – no.

Debt is an issue only if you can’t repay it or if other people believe you can’t repay it. And, as Business Insider’s Myles Udland has noted, the US can literally print the money it needs to repay its debt, and it still maintains a high credit rating.”

Bob is correct. The “fear mongering” over debt levels, and President Obama’s threats of default if we “shut down the government,” are just that – fear mongering. Entitlements and interest payments are mandatory expenditures of the government which get paid regardless of whether the Government is shut down or not.

However, what Bob misses is the much bigger point which is the impact on debt levels as it relates to economic prosperity.

According to Keynesian theory, some microeconomic-level actions, if taken collectively by a large proportion of individuals and firms, can lead to inefficient aggregate macroeconomic outcomes, where the economy operates below its potential output and growth rate (i.e. a recession).

Keynes contended:

A general glut would occur when aggregate demand for goods was insufficient, leading to an economic downturn resulting in losses of potential output due to unnecessarily high unemployment, which results from the defensive (or reactive) decisions of the producers.”  

In other words, when there is a lack of demand from consumers due to high unemployment, the contraction in demand would force producers to take defensive actions to reduce output.

In such a situation, Keynesian economics states:

Government policies could be used to increase aggregate demand, thus increasing economic activity and reducing unemployment and deflation. Investment by government injects income, which results in more spending in the general economy, which in turn stimulates more production and investment involving still more income and spending and so forth. The initial stimulation starts a cascade of events, whose total increase in economic activity is a multiple of the original investment.

Keynes’ was correct in his theory. In order for government deficit spending to be effective, the “payback” from investments being made through debt must yield a higher rate of return than the debt used to fund it.

The problem is that government spending has shifted away from productive investments that create jobs (infrastructure and development) to primarily social welfare and debt service which has a negative rate of return.  According to the Center On Budget & Policy Priorities nearly 75% of every tax dollar goes to non-productive spending. 

policybasics-wheretaxdollarsgo-f1

Here is the real kicker, though. In 2014, the Federal Government spent $3.5 Trillion which was equivalent to 20% of the nation’s entire GDP. Of that total spending, $3.15 Trillion was financed by Federal revenues and $485 billion was financed through debt. In other words, it took almost all of the revenue received by the Government just to cover social welfare and service interest on the debt. In the financial markets, when you borrow from others to pay obligations you can’t afford it is known as a “Ponzi-scheme.” 

Debt Is The Cause, Not The Cure

Debt, if used for productive investments, can be a solution to stimulating economic growth in the short-term. However, in the U.S., debt has been squandered on increases in social welfare programs and debt service which has an effective negative return on investment. Therefore, the larger the balance of debt becomes, the more economically destructive it is by diverting an ever growing amount of dollars away from productive investments to service payments.

The relevance of debt growth versus economic growth is all too evident as shown below. Since 1980, the overall increase in debt has surged to levels that currently usurp the entirety of economic growth. With economic growth rates now at the lowest levels on record, the growth in debt continues to divert more tax dollars away from productive investments into the service of debt and social welfare.

Debt-GDP-Presdient-050216-2

It now requires $3.71 of debt to create $1 of economic growth.

Debt-GDP-Growth-022216

In fact, the economic deficit has never been greater. For the 30-year period from 1952 to 1982, the economic surplus fostered a rising economic growth rate which averaged roughly 8% during that period. Today, with the economy growing at an average rate of just 2%, the economic deficit has never been greater.

Debt-Economic-Deficit-022216

But it isn’t just Federal debt that is the problem. It is all debt.

When it comes to households, which are responsible for roughly 2/3rds of economic growth through personal consumption expenditures, debt was used to sustain a standard of living well beyond what income and wage growth could support. This worked out as long as the ability to leverage indebtedness was an option. The problem is that eventually, the debt reaches a level where the level of debt service erodes the ability to consume at levels great enough to foster stronger economic growth.

In reality, the economic growth of the U.S. has been declining rapidly over the past 35 years supported only by a massive push into deficit spending by households.

PCE-Wages-GDP-Debt-040416

What was the difference between pre-1980 and post-1980?

From 1950-1980, the economy grew at an annualized rate of 7.70%. This was accomplished with a total credit market debt to GDP ratio of less 150%.

The CRITICAL factor to note is economic growth was trending higher during this span going from roughly 5% to a peak of nearly 15%. There were a couple of reasons for this. First, lower levels of debt allowed for personal savings to remain robust which fueled productive investment in the economy. Secondly, the economy was focused primarily on production and manufacturing which has a high multiplier effect on the economy.  This feat of growth also occurred in the face of steadily rising interest rates which peaked with economic expansion in 1980.

The obvious problem is the ongoing decline in economic growth over the past 35 years has kept the average American struggling to maintain their standard of living. As wage growth stagnates or declines, consumers are forced to turn to credit to fill the gap in maintaining their current standard of living. However, as more leverage is taken on, the more dollars are diverted from consumption to debt service thereby weighing on stronger rates of economic growth.

Austrian’s Might Have It Right

The massive indulgence in debt, what the Austrians refer to as a “credit induced boom”, has now reached its inevitable conclusion.  The unsustainable credit-sourced boom, which leads to artificially stimulated borrowing, seeks out diminishing investment opportunities. Ultimately these diminished investment opportunities lead to widespread mal-investments. Not surprisingly, we clearly saw it play out “real-time” in everything from sub-prime mortgages to derivative instruments which was only for the purpose of milking the system of every potential penny regardless of the apparent underlying risk.

Debt-Austrian-Theory-022216

When credit creation can no longer be sustained the markets must begin to clear the excesses before the cycle can begin again. It is only then, and must be allowed to happen, can resources be reallocated back towards more efficient uses. This is why all the efforts of Keynesian policies to stimulate growth in the economy have ultimately failed. Those fiscal and monetary policies, from TARP and QE to tax cuts, only delay the clearing process. Ultimately, that delay only potentially worsens the inevitable clearing process.

That clearing process is going to be very substantial. The economy is currently requiring roughly $4 of debt to create $1 of economic growth. A reversion to a structurally manageable level of debt would involve a nearly $30 Trillion reduction of total credit market debt from current levels. 

Debt-Structurally-Maintainable-Level-022216

The economic drag from such a reduction would be a devastating process which is why Central Banks worldwide are terrified of such a reversion. In fact, the last time such a reversion occurred the period was known as the “Great Depression.”

Debt-GDP-Annual-022216

This is one of the primary reasons why economic growth will continue to run at lower levels going into the future. We will witness an economy plagued by more frequent recessionary spats, lower equity market returns and a stagflationary environment as wages remain suppressed while costs of living rise.

Bob is correct. $19 Trillion isn’t a problem for us to pay because we can simply “print money” to make those payments, not withstanding the negative consequences of doing so. However, there is an apparent problem as it relates to growth. Correlation? Maybe. Causation? Probably.


Lance Roberts

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Lance Roberts is a Chief Portfolio Strategist/Economist for Clarity Financial. He is also the host of “The Lance Roberts Show” and Chief Editor of the “Real Investment Advice” website and author of “Real Investment Daily” blog and “Real Investment Report“. Follow Lance on Facebook, Twitter, and Linked-In