LXV Research

Inflation, Earnings Yields, Stock Prices and Gold

We examine the relationships between inflation, stock prices, valuation multiples, real yields and gold. 15 Nov 2019.

“To understand is to perceive patterns.” ― Sir Isaiah Berlin (1909 – 1997)

“The great hope for a quick and sweeping transition to renewable energy is wishful thinking.” ― Vacliv Smil

Amazon has been in the news lately and not for the right reasons:

Nike has ended its deal with Amazon to sell its shoes and clothing directly to consumers on the e-commerce website. Nike cited a lack of follow through on Amazon’s part to crack down on sales of Nike branded products by unlicensed distributors and knockoffs by third-party sellers.

Amazon has accused the US government of having exhibited an “unmistakable bias” for the Pentagon awarding the US dollars 10 billion Jedi cloud computing contract to Microsoft after several rounds of bidding.

All does not seem right at Amazon. Probably making it one of the large cap stocks to avoid even as the US equity market continues to head higher.

On to this week’s update.

Inflation, Earnings Yields, Stock Prices and Gold

Federal Reserve Chairman Jay Powell told lawmakers at the Congressional Testimony that he saw little need to cut interest rates further after making three reductions since July. He also expressed that US inflation should progressively rise toward the Fed’s target rate of 2 per cent.

The day before Chairman Powell’s testimony, President Trump criticised the Fed for keeping rates too high and expressed envy towards nations in Europe that have interest rates below zero.

President Trump, understandably, wants higher stock prices and a booming economy as the US heads into an election year. Since stock prices are supposed to reflect the values of discounted future cash flows, a lower discount rate and / or high earnings growth expectations should translate into higher stock prices. President Trump cannot goose up earnings as easily as the Fed can cut interest rates, from his perspective, it then makes sense that he goes after the Fed and its hawkish stance, relative to that of the European Central Bank and Bank of Japan, on monetary policy.

Assuming lower policy interest rates translate into a lower discount rate, the US equity market’s earnings yield should decline (or price-to-earnings ratio increase). Barring a sharp drop in earnings, a lower earnings yield equates to higher stock prices.

The fly in the ointment is that, historically, US earnings yields have been more closely related to the rate of inflation than to nominal or real bond yields. And, high price-to-earnings ratios have had modest predictive power over future earnings growth.

The chart below is of the trailing earnings yield of US stocks and realised inflation rates.

Earning Yield and Inflation.png

A comparable relationship between inflation and earnings yields exists in many other markets as well.

Theoretically, since stocks are real assets, changes in the rate of inflation should not have a meaningful impact on stock prices or valuation multiples. In practice, however, the principle does not hold. Studies in behavioural finance suggest that a cognitive bias, known as the “money illusion”, explains the theoretical and practical disconnect that makes equity markets undervalued when inflation is high and overvalued when inflation is low.

The money, or price, illusion is to think of money in nominal, rather than real, terms. That is, when inflation is high (low), market participants incorrectly discount real cash flows using nominal discount rates, resulting in an undervalued (overvalued) price.

Explanations based on cognitive biases, such as the money illusion, while appealing, lack explanatory power however. That is, analysis reveals the ‘sweet spot’ for equity valuations occurs when the rate of inflation is in the range of 1 to 4 per cent. Valuation ratios compress at rates of inflation both above and below this range. Markets like neither high-levels of inflation nor deflation.

This is bad news for long-term equity investors that consider the probability of one of either deflation or high inflation occurring in the future to be higher than the level of inflation being witnessed in the US economy at present.

Relation Between Gold and the Price-to-Earnings Ratio

PE vs SPGOLD.png

The above is a chart of the S&P 500 Index express in terms of gold (in US dollars per Troy Ounce) versus the index’s price-to- ratio. In simple terms, the price of gold is inversely correlated to the price-to-earnings multiple of the index.

This relation can be better visualised by using the cyclically adjusted price-to-earnings (CAPE), or Shiller price-to-earnings, ratio as the impact of the Global Financial Crisis is smoothed out.

CAPE SPGOLD.png

Outside of periods when demand for high-quality, liquid collateral is at a premium, such as during a financial crisis, the price of gold is generally driven by the trend in US real yields. Rising real yields, that is rising interest rates and / or declining inflation, tend to push gold lower. While declining real yields, that is declining interest rates and / or rising inflation, tend to push gold higher.

The critical question for investors in US equity markets, or any other stock market for that matter, to ask then is: where are real yields headed?

Higher real yields translate into expanding valuation multiples implying that positive returns can be generated even with benign levels of earnings growth. While shrinking real yields are likely to spell negative returns unless earnings really surprise to the upside.

With Mr Powell signalling that the Fed is done cutting rates for now, if a drop in real yields is to manifest, it is more likely to come from a spike in inflation. With the continued reluctance of US corporations to make capital investments, the most likely candidate to lead a spike in inflation, in our opinion, is an unexpected rise in the price of oil.

Equity market multiple contraction risk can be hedged by owning gold or by investing in oil related plays such as companies operating in the energy sector. With gold having rallied to multi-year highs just recently and energy stocks trading at or near multi-year lows, our preference is for the latter.

This post should not be considered as investment advice or a recommendation to purchase any particular security, strategy or investment product. References to specific securities and issuers are not intended to be, and should not be interpreted as, recommendations to purchase or sell such securities. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed.

China’s Priorities | Industrial Strength $XLI

“And the little screaming fact that sounds through all history: repression works only to strengthen and knit the repressed.” ― The Grapes of Wrath by John Steinbeck

China’s Priorities

From the Wall Street Journal (emphasis added):

In the trenches of China’s debt-addled economy, the government has made a startling decision: Let companies fail.

That has left creditors angry, debtors fighting to save their businesses and judges on a mission to promote the benefits of bankruptcy.

After years of pumping out financial support to keep the economy humming and workers happy, China has embarked on a debt reckoning. Beijing is building a bankruptcy system to take on a significant pickup in corporate defaults.

The country now has more than 90 U.S.-style specialized bankruptcy courts to help sort through a morass of corporate debt that, until recently, would have been swallowed by state banks and other creditors.

It is a sign that Beijing is worried about the number of failing companies and trying to find a fix. The system is helping, many lawyers, foreign investors and lenders say, as it takes some pressure off local governments that lack the resources for so many bailouts.

[…]

China introduced formal bankruptcy laws in 2007. But courts routinely rejected applications from struggling businesses and their creditors because of concerns over potential social unrest and large-scale layoffs.

Many insolvent companies chugged along with state subsidies and loans from state-owned banks. Some simply walked away from their debts, leaving creditors hanging.

[…]

It is part of a shift from what Judge Ye described as policy-mandated bankruptcy—the government largely decides which companies fail or survive—to a “market-oriented bankruptcy” process that lets market forces decide who are the winners and losers.

While some cultural blowback is to be expected, this is a positive development. If China is going to transition from an investment-led to a more balanced economy, malinvestment needs to be discouraged. Market-oriented bankruptcy proceedings replacing government-led bailouts is a welcome step in the right direction.

Household, or private, consumption accounted for less than 40 per cent of China’s GDP in 2018, the thirteenth consecutive year in which private consumption has accounted for less than 40 per cent of GDP. Such persistently low-levels of private consumption, as a share of GDP, are unprecedented in recorded economic history. Given the magnitude of and the prolonged period over which the Chinese consumer has been repressed, China’s leadership is unlikely to be able to encourage households into increasing spending merely by tweaking policy. Difficult policy decisions will need to be made and stuck with. Discouraging and allowing markets to punish corporate malinvestment is once such decision.

Malinvestment is a direct consequence of over-investment. Over-investment requires an abundance of domestic savings or the ability to attract high-levels of foreign direct investment.

Foreign private investors require some form of protection when investing in jurisdictions where the political risk-premium is high. The protection for investing in China was provided by its burgeoning pile of net foreign assets.

In the chart below, in the top panel the magenta line is the level of foreign exchange reserves held by China and the bars in bottom panel represent the cumulative foreign direct investment into the Mainland since 1995. The two series have been in almost perfect lockstep.

China Reserves vs FDI.jpg

The rest-of-the-world is becoming increasingly unable and unwilling to absorb China’s trade surpluses. Thereby inhibiting further increases in Chinese foreign exchange reserves and by extension the flow of foreign capital into the Mainland.

Lower appetite for Chinese trade surpluses implies lower demand for Chinese exports. Lower Chinese exports in turn means the investment needs of Chinese corporates are reduced.

From the Financial Times:

China’s listed manufacturers are increasingly putting their money into financial assets such as stocks and bonds rather than investing in their own businesses, as the potential returns from capital expenditure wane.

To curb speculation and malinvestment, there needs to be an increase consumption in China. Consumption will only increase once the powers that be put to an end to their policies of financial repression. That is, an end to artificially low interest rates that penalise depositors for the benefit of large corporates, excessive levels of direct and indirect subsidies to state-owned enterprises and an undervalued currency. Additionaly, the burden of creating social safety nets needs to be removed from households and placed it on the state.

China does not need 6 per cent plus of GDP growth, it needs private consumption growth of 3 to 4 per cent above the rate of GDP growth for the next decade, or possibly even longer. The People’s Bank of China this week rolling over its one-year medium-term lending facility at 3.25 per cent, 5 basis point below the previous rate of 3.3 per cent, and setting the direction of monetary policy toward easing, suggests GDP growth not household consumption growth remains the priority for Chinese policymakers.

Industrial Strength

This has been a difficult year for American manufacturers, marked by trade war related changes and an almost synchronised global economic slowdown. Output, investment and employment are all down at US manufacturing companies and surveys revealed manufacturers to be less than optimistic on near-term prospects.

With that in mind, consider the below chart of the Industrial Select SPDR ETF $ XLI.

Industrial stocks are breaking out to all-time highs and that too on improving relative strength (second panel above).

The following constituents of the ETF appear to the most interesting from the long-side.

Fastenal $FAST

Fastenal resells industrial, safety, and construction supplies such as such as screws, threaded rods, and nuts and offers services including inventory management, manufacturing, and tool repair.

FAST

Rollins Inc. $ROL

Rollins Inc. provides essential pest control services and protection against termite damage, rodents and insects.

Pentair $PNR

Pentair sells comprehensive range of smart, sustainable water treatment solutions to homes, business and industry globally.

PNR

Alaska Air $ALK

Owner and operator of two US based airlines: Alaska Airlines and Horizon Air.

Signs of Rotation: Geography, Sector and Style

“There is no nonsense so errant that it cannot be made the creed of the vast majority by adequate governmental action.” ― Bertrand Russell (1872 – 1970), British Nobel laureate in literature

From The Toxic Bubble of Technical Debt Threatening America by The Atlantic:

“A kind of toxic debt is embedded in much of the infrastructure that America built during the 20th century. For decades, corporate executives, as well as city, county, state, and federal officials, not to mention voters, have decided against doing the routine maintenance and deeper upgrades to ensure that electrical systems, roads, bridges, dams, and other infrastructure can function properly under a range of conditions. Kicking the can down the road like this is often seen as the profit-maximizing or politically expedient option. But it’s really borrowing against the future, without putting that debt on the books.

In software development, engineers have long noted that taking the easy way out of coding problems builds up what they call “technical debt,” as the tech journalist Quinn Norton has written.

[…]

Almost everywhere you look in the built environment, toxic technical-debt bubbles are growing and growing and growing. This is true of privately maintained systems such as PG&E’s and publicly maintained systems such as that of Chicago’s Department of Water Management. It’s extremely true of roads: Soon, perhaps 50 percent of Bay Area roads will be in some state of disrepair, not to mention the deeper work that must occur to secure the roadbeds, not just the asphalt on top.”

The Federal Reserve cut interest rates for the third time this year while also signalling that it does not expect to reduce rates further barring a sharp slowdown in the economy.

Suppression of G-7 interest rates, particularly following the bursting of the dotcom bubble and then the Global Financial Crisis, enabled gross over indebtedness, severe misallocation of capital and moral hazards to build up globally. This leaves governments and central banks with little choice but to respond to any signs of instability with further stimulus, either fiscal or monetary, to avoid the inevitable asset impairment cycle that would lead to a deflationary bust.

Suppressing interest rates slowly erodes trust in the financial system by facilitating the survival of zombie companies and unstable financial structures. The complete obliteration of trust in the financial system ultimately begets high rates of inflation and rewards owners of real assets.

Ideologically, we understand and appreciate the case for a complete loss of confidence in the dollar-based financial system and the eventual breakout of high inflation. And barring a discovery that materially reduces energy costs and increases supply at the same time, or a step-up in global productivity of the like witnessed during the industrial revolution, we expect the end game for the current global order to be no different than to that of other regimes in history.

In the theory of complex systems there is a concept of the ‘adjacent possible’ ― the set of all possible states of the world that could potentially exist in the next time step, given the present state of the world. Understanding the current state of the world then drastically reduces the next possible state of the world from all possible states to a subset of possibilities that are conditional on the present.

Ideologies aside, our analytical framework does not yet consider a complete loss of trust in the global financial system in the adjacent possible. Rather, the next crisis, whenever it may be, and the response to it by governments and central banks is likely to sow-the-seeds for the obliteration of trust in global financial systems.

On to this week’s update.

Signs of Rotation: Geography, Sector and Style

Global equities are on track for a third-successive week of positive returns driven by easing financial conditions, diminishing Brexit uncertainty, prospects of a thawing of tensions in the US-China trade dispute, and US earnings season going better than anticipated. (US companies are beating earnings expectations by ~5 per cent; notably, the bar had been lowered heavily with consensus expectations slating earnings per share to decline 3 per cent year-over-year.)

In the recent upturn there have been some noticeable rotations across sectors, geographies and styles. With the short-term outperformance of value over growth getting the most airtime.

While notable on a shorter-term horizon, most rotations appear trivial relative to performance trends during this record-long business cycle. For example, over the past decade non-US equities have delivered returns only one-third of US ones, measured in USD terms, while the iShares Russell 1000 Growth ETF has delivered a total return more than 1.5 times the total return delivered by the iShares Russell 1000 Value ETF.

With that being said, we run through a series of charts of identify regions, sectors and styles benefiting from rotation, albeit in the short-term, and could provide tactical alpha generating opportunities.

The Rest of the World

Value is often discussed in terms of the value and growth indices in the US. Given, the relatively paltry returns from non-US markets over the last decade, one could argue that anything non-US is essentially a value play.

With a dovish Fed, the easing trade dispute and a cyclically weaker US dollar, we can envision a scenario where money managers look to shift allocations into non-US markets lured by any one or a combination of value, reflationary pressures or improving growth prospects. The one difference we anticipate in any geographical reallocations in this cycle versus previous cycles is investors no longer analysing emerging markets simply through the prism of China. Rather, we expect a more discerning, less-homogeneous approach to emerging markets as investors attempt to identify winners and losers of the fallout from the US-China trade dispute.

US to World.png

We expect the next two to three months to be favourable for the rest-of-the-world relative to the US and for non-US equity markets to match or better US equity markets.

Russia

Russia looks one of the most attractive markets relative to both the US (first chart) and the world ex-US (second chart).

RSX SPY.png

RSX RoW.png

Brazil: Long-Only and Relative to Mexico

Brazil is shaping up well against the broader emerging markets space (first chart) and long Brazil $EWZ with short Mexico $EWW is a pair trade (second chart) that we would look to put on.

EWZ EEM.png

Why? Because Brazil has pro-business government and the potential to increase agriculture sales to China should the trade-dispute once again escalate while Mexico has a socialist leader and is running a record trade surplus with the US.

EWZ EWW.png

Europe Relative to Japan / The UK Against Germany

Another pair trade that we like is long European equities $VGK and short Japanese equities $EWJ. Japanese equities need not go down but the Japanese could weaken relative to the euro as Brexit uncertainties are mitigated and the general risk-on environment gathers steam.

VGK EWJ.png

The above trade could combine well with long the UK $EWU and short Germany $EWG and hedge out some of the risks emanating from the continued industrial slowdown in Germany. However, an outright long in the UK (second chart) looks a better trade should sentiment continue to remain ebullient.

EWU and EWG.png

Sectors

Autos

The automotive sector has been one of the worst hit in recent years with the stringent emissions standards going into force Europe, removal of tax subsidies in China on auto purchases and the chaotic implementation of new emission standards in China this past summer. With comps likely to be easier on a year-over-year basis at the end of this year and early next year, autos could surprise to the upside in performance.

We are not quite ready to go long here but should the sector gather further momentum $CARZ could be a high beta long to play risk on sentiment.

Energy

Given the low long-to-short ratio in futures markets, CTAs limit short oil any positive trade developments, supportive crude demand from refineries returning from maintenance, and prospects of deeper OPEC+ cuts could prompt a sharp rally in oil and energy names.

In the chart below we can see the horrendous performance of $XLE relative to $SPY. Energy has been a long-running pain trade. The risk-to-reward is tempting especially with the number of active oil rigs in the US below 700 for the first time since 2017.

XLE SPY.png

Eight US Stocks We Are Tracking

“Never forget the trail, look ever for the track in the snow; it is the priceless, unimpeachable record of the creature’s life and thought, in the oldest writing known on the earth.” ― Ernest Thompson Seton, from Mammal Tracks and Sign

We share charts of eight US stocks we are tracking for 8 potential long positions, 1 short position and for a feel for the general direction of key market sectors and the broader market.

Walmart $WMT

Retail behemoth that is a potential long with a tight stop-loss just below $120.

Google $GOOG

A buy stop just above all-time highs could be a good way to play this if it breaks higher post earnings.

SurveyMonkey $SVMK

A software play where we are looking for a daily close above $19.00.

Silicon Labs $SLAB

Fabless global technology company that designs and manufactures semiconductors, other silicon devices and software. We are looking for a weekly close above $115.

Floor & Decor $FND

We are looking for a weekly close above $50 for the multi-channel American specialty retailer of hard surface flooring and related accessories.

Qualcomm $QCOM

A weekly close above $80 would be enticing.

EMCOR Group $EME

The mechanical and electrical engineering services groups is a potential long on a weekly close above $90.

FireEye $FEYE

This cyber-security stock looks a good short here with a tight buy stop just above $16.50.

Tribalism and Consistency in a Volatile Market

A somewhat lengthy piece discussing some of the psychological hindrances all of us face from time-to-time in investing and trading pursuits.

We share one chart right at the end of the piece with little comment, which is the basis of our expectation that the US equity market is to see new highs still.

The Science of Tribalism

“Everybody wants to protect their own tribe, whether they are right or wrong.” ― Charles Barkley

While watching television, have you ever looked away or squealed in response to a gruesome scene, the kind that became a regular occurrence on HBO’s Game of Thrones? Turns out, this is because the imagery activates our brain’s empathy network, which then stimulates brain areas involved in the sensation of our own pain.

Neuroimaging studies have revealed that watching another person in pain triggers brain areas that are active when we feel pain. The neural response to seeing others in pain, however, is not constant; rather it is modulated by context and by allegiances.

Neuroscientist David Eagleman used functional magnetic resonance imaging (fMRI) to measure the response in the brain’s empathy network. He examined the brains of people watching videos of other people’s hand getting pricked by a needle or touched by a Q-tip. When the hand being pricked by the needle was labelled with the participant’s own religion, the participant’s empathy network showed a larger spike of activity than when the hand was labelled with a different religion.

More surprisingly, when participants were assigned to an arbitrary group immediately before the subject entered the MRI machine, and the hand being pricked was labelled as belonging to the same arbitrary group as the participant, the participant’s brain still showed a larger spike ― even though the grouping did not exist just moments earlier!

Participants also exhibited a diminished response in their empathy networks if they believed the pain-recipient has acted unfairly in a simple economic exchange or were told that the victim is receiving a large monetary compensation for undergoing the pain.

Commitment and Consistency

“Consistency is the hallmark of the unimaginative.” ― Oscar Wilde

Last week we were forwarded a quarterly commentary and portfolio review for a fund managed by a self-proclaimed “old-school value investor”. The commentary was standard fare really, espousing the well-known values of Graham and Dodd and Buffet and Munger schools of investing as would be expected from a value-oriented manager. The fund manager was particularly insistent that they only buy “companies at a big discount to the present value of their future cash flows”.

As we turned to the section listing the fund’s top holdings, that too read like a standard portfolio that we had seen from countless other value managers. There was a lot of Google in the portfolio, a little Apple, a few big-name financial stocks and a not-so-insignificant allocation to General Motors. Except there was one holding which we did not expect, Netflix. And seeing it in the list of holdings, one of top-five in terms of allocation, irked us. Reading the commentary already felt like it was not the best use of our time but after seeing Netflix in the portfolio, the feeling changed to that of being cheated somehow.

Feeling cheated after reading the commentary and seeing the holdings for a fund we are not invested in, strange right?

The following passage is excerpted from Influence: The Psychology of Persuasion by Robert B. Caldini (emphasis added):

Psychologists have long understood the power of the consistency principle to direct human action. Prominent early theorists such as Leon Festinger (1957), Fritz Heider (1946), and Theodore Newcomb (1953) viewed the desire for consistency as a central motivator of behavior. Is this tendency to be consistent really strong enough to compel us to do what we ordinarily would not want to do? There is no question about it. The drive to be (and look) consistent constitutes a highly potent weapon of social influence, often causing us to act in ways that are clearly contrary to our own best interest.

Consider what happened when researchers staged thefts on a New York City beach to see if onlookers would risk personal harm to halt the crime. In the study, an accomplice of the researchers would put a beach blanket down five feet from the blanket of a randomly chosen individual—the experimental subject. After several minutes of relaxing on the blanket and listening to music from a portable radio, the accomplice would stand up and leave the blanket to stroll down the beach. Soon thereafter, a researcher, pretending to be a thief, would approach, grab the radio, and try to hurry away with it. As you might guess, under normal conditions, subjects were very reluctant to put themselves in harm’s way by challenging the thief—only four people did so in the 20 times that the theft was staged. But when the same procedure was tried another 20 times with a slight twist, the results were drastically different. In these incidents, before leaving the blanket, the accomplice would simply ask the subject to please “watch my things,” something everyone agreed to do. Now, propelled by the rule for consistency, 19 of the 20 subjects became virtual vigilantes, running after and stopping the thief, demanding an explanation, often restraining the thief physically or snatching the radio away (Moriarty, 1975).

To understand why consistency is so powerful a motive, we should recognize that, in most circumstances, consistency is valued and adaptive. Inconsistency is commonly thought to be an undesirable personality trait (Allgeier, Byrne, Brooks, & Revnes, 1979; Asch, 1946). The person whose beliefs, words, and deeds don’t match is seen as confused, two-faced, even mentally ill. On the other side, a high degree of consistency is normally associated with personal and intellectual strength. It is the heart of logic, rationality, stability, and honesty.

The fund manager was inconsistent. He championed investing in “companies at a big discount to the present value of their future cash flows” and then went ahead and owned Netflix. The gall of it!

The Incompatibility of Tribalism and Consistency in a Volatile Market

Our vocation is such that we are often engaged in debate. On the merits of buying one security over another. On the signals from one asset class for the prospects of another asset class. On the reaction function of the Federal Reserve to the latest release of economic data. And on many other topics much like these.

Over the last eighteen or so months, markets have been extraordinarily challenging.

US stocks have rallied, sold off, rallied sharply, sold off sharply, rallied sharply and now started to chop. G-7 governments have sold-off with the US ten-year reaching yields of 3 per cent and then rallied to record low yields. The trade-dispute between the US and China has escalated, de-escalated and escalated again on more occasions than we care to recall. Bitcoin lost more than two-thirds of its value, then tripled and then halved. Repo rates spiked for reasons no-one can fully comprehend. Oil witnessed the re-emergence of a geopolitical premium only for it to subside almost instantly.

In our discussions and debates, we have found that a fair share of traders, active managers and asset allocators are, more than ever, struggling to keep up, let alone outperform, broader market indices. Markets are never easy, in these challenging climes even less so. Nonetheless, two of the recurring hindrances to better performance we have increasingly noticed are tribalism and consistency.

Tribalism in Social Media and Investment Decision Making

Tribalism can be easy to spot. Just go on to Twitter and you will find bond bulls re-tweeting bond bulls, goldbugs sharing articles of Paul Tudor Jones stating that gold is his best idea for the next two years, equity market bears praising the analysis of other bearish analysts, Tesla bulls and bears slinging mud at each other, the examples are countless. Worse still, try debating with someone you do not know but disagree with and present factual data that invalidates their view and you are likely to be blocked more often than you would expect.

Tribalism in a social media context leads to filter bubbles and to the consumption of news, views and research that confirms that which we already know or believe. The utility of a social media platform, such as Twitter, to a user is significantly reduced by tribal behaviour. It has never been easier, faster and cheaper to seek out and obtain a variant perception. Investment professionals and traders would be better served and probably see improving performance if they used social media platforms more to seek out non-conforming views rather than searching for the false sense of security that belonging to arbitrary Twitter tribe would bring.

In professional settings tribalism is less of a problem but at the same time harder to spot. At investment firms, it usually manifests in team members with non-consensus views or opinions being cast aside in the investment decision making process.

Tribalism can lead to poor investment decision making when good ideas are rejected because they are put forth by those long belonging to the ‘other tribe’ and bad ideas presented by those belong to ‘our tribe’ are accepted.

Worse still, is the case of tribal behaviour on social media that creeps into professional settings. If you are wondering if it really happens, we recently attended a meeting with a prospective client where one of the analysts quoted recent tweets by three, to remain unnamed, permabears to make a case against an allocation to US equities.

Consistency is the Real Enemy

“Laziness isn’t merely a physical phenomenon,about being a couch potato,stuffing your face with fries and watching cricket all day. It’s a mental thing, too, and that’s the part I have never aspired for.” ― Shah Rukh Khan, Indian actor, film producer, and television personality

While tribalism can be toxic, it is consistency that can be the real enemy in the investment decision making process.

Since a “high degree of consistency is normally associated with personal and intellectual strength” it usually serves one’s interests to remain consistent. The downside, however, is that this fosters almost blind consistency which is detrimental, and at times outright disastrous, in the process of investment decision making.

Blind consistency, outside of investment decision making, has its attractions. For starters, it frees up our mental resources by giving us a relatively effortless means for dealing with the complexities of daily life that make severe demands on our mental energies and capacities. Having made up our mind about an issue, blind consistency allows us to stop thinking about the issue and when confronted with the issue we only react in a manner consistent with our earlier decision.

Another attraction of mechanically reacting to an issue is that it protects us from the uncomfortable truth that we may be wrong. If we never expend the energy to understand the counter-argument, and reject it off the bat, we never have to confront the possibility that we may wrong.

Consider the following (real life) examples and if any resonate with you.

Bond bulls who will exit their bonds positions to lock in profits but will never go long stocks because a recession is always just around the corner.

– Gold bears that short at the lows because it’s a ‘barbarous relic’ and fail to cover or go long even as real rates are collapsing.

– Federal Reserve critics that see every market jitter as further confirmation of central banker incompetence but have not taken the time to understand the intricacies of the financial system.

– US dollar bulls that never go long another currency against the greenback even as it becomes painfully obvious that a rally has become over stretched.

– Permabears that told you that Apple was done after the ‘failed’ iPhone 5 and now poo-poo over the company’s services narrative.

– The bearish fund manager that identifies the flaw in his framework that led them to catastrophically underperform over the last decade somehow finds that the updated framework indicates that is time to short US stocks.

– The technical analyst that shows you analogs of today’s US market performance versus sometime leading up to the crash in 1929, 1987, 2008 or any other market crash that can be found or compressed to fit the narrative but never one that shows the market going higher.

All of the above examples are of blindly consistent people. In any other context you would respect them. In an investment context, they would have at times cost you money, a lot of it. In many instances it is acceptable to underperform. It is, however, unacceptable to underperform because you were unwilling to do the work or to appear inconsistent.

Improving Liquidity Indicators Suggest New Highs Still to Come

Combine the below with the three charts we shared last week and the prospect of the S&P 500 reaching levels 10 to 15 per cent higher from here is not altogether unreasonable.

Thanks for reading and please share!

Three Macro Charts

“We can chart our future clearly and wisely only when we know the path which has led to the present.” ― Adlai Stevenson I, 23rd Vice President of the United States of America

A short piece with three macro charts and limited commentary.

1. Global Risk

Data validating recessionary fears have been the flavour du jour recently. The below is a chart of the MSCI All Cap World Index and the twelve-month moving average of the Citi Macro Risk Index, which suggests that a cyclical upturn in global equities is probable.

It is not the magnitude rather the direction of the risk index that acts as a cyclical indicator.

A similar sell-off to that witnessed in the fourth quarter of 2018 is not inevitable in the fourth quarter of 2019.

2. Cyclical USD

A custom leading index of global financial conditions suggests the cyclical trend for the USD is lower, even as the secular trend of the greenback remains intact.

3. Secular Trend in Real Yields

Quoting the National Bureau of Economic Research:

“The large and growing US current account deficits resulted from the large volume of foreign savings pushing in, as indicated by the declining US real interest rates, and not from US ‘profligacy’.”

The below chart is of the sum of foreign reserves held by China and Japan (inverted) and the real US 10 year treasury yield, for the period starting right after the Asian Financial Crisis.

The Asian Financial Crisis set in motion the trend of rising current account surpluses in Asia that were funneled back into the US. One major leg that furthered the trend, Chinese savings being recycled into US assets, has been broken by the protectionist policies of the US and economic challenges China is facing up to domestically.

The recycling of Asian current account surpluses into US assets is coming to end at the same time the US is entering a demographic driven inflationary phase, as argued by the Bank for International Settlements.

The secular tailwinds that drove down real yields in developed economies are weakening.

Thanks for reading and please share!

Nothing Unusual | MMT

“There are decades where nothing happens; and there are weeks where decades happen.” ― Vladimir Lenin

“There is nothing so permanent as a temporary government program.” ― Milton Friedman

What an eventful few weeks!

Prime Minister of the United Kingdom, Boris Johnson, suspended Parliament for five weeks in the run up to the Brexit decision in an attempt to hijack proceedings and has now been found by the Supreme Court to have acted “unlawfully”.

An aerial attack took place on Saudi Aramco’s facilities at Abqaiq and temporarily took out more than 5 million barrels a day of crude oil production ― representing roughly the equivalent of 5 per cent of global oil supply. The price of oil spiked by almost 20 per cent on the news but has fall back to levels prior to the attack following assurances from the Saudi Arabian government to quickly ramp up production.

The We Company, purveyors of the WeWork brand of office space, has seen its prospective IPO unceremoniously unravel, culminating with the board room coup by Masayoshi Son-led Softbank and the ousting of co-founder and CEO Adam Neumann.

Overnight borrowing rates in the repurchase or repo market, where traders do short-term deals to swap Treasuries for cash, suddenly rose to 10 per cent, up from their normal levels of 2-2.5 per cent. (Something we touched upon in January.)

And most recently, Speaker of the House of Representatives, Nancy Pelosi, announced that the House will proceed with an “official” impeachment against President Trump.

All of this is unfortunate; none of it feels unusual anymore and maybe explains why the S&P 500 is barely 2 per cent from all-time highs.

On to this week’s update.

Modern Monetary Theory

The course of markets is unpredictable, crooked as the corrupt, companies rising and falling by whim and chance, bated by politicians, manipulated by greed, taken hold of by the unscrupulous, rattled by rogues, addled by analysts.

This has all been true since there have been markets. It still holds true today. The reality, however, has not discouraged attempts to chart the motions of prices and model the behaviour of markets as if these were matters of physics, like gravity and the coming and goings of the tides. New business models, novel algorithms, ‘structured’ products and twists on age-old policies have been unveiled at different points in history to mark the start of a new era, in which the course of markets might be made predictable, investment returns consistent and the behaviour of market participants that would be ruled not by fear and greed but by reason and rationality. The goals are always lofty, and their fate always the same.

The current incarnation of these less-than-illustrious elixirs being promoted is Modern Monetary Theory (or MMT in more common parlance). In this week’s piece, we take a much overdue look at MMT.

Before going on to the specifics of MMT, however, a few fundamental concepts are summarised so that the conclusions drawn are coherent.

Private vs Public Asset Creation

Private asset creation, including money is less susceptible, on a system-wide basis, to miscalculation and misallocation than government led asset creation, which is subject to the vagaries of politicians and public sector bureaucracy, which lead to miscalculation and gross misallocation.

If government created assets occupy an increasing share of system-wide assets at the expense of the more sound, private sector created assets, there is greater misallocation and confidence in the monetary system is gradually eroded.

The Role of Central Banks in Asset Creation

Central banks, particularly in developed economies, are responsible for less than 10 per cent of money and liquidity creation in the financial system.

Nine-tenths or greater of the money in the financial system today is actually deposits held within commercial banks and their equivalents. Deposits, are of course, created by commercial banks engaging in the acts of lending or investing. The prevailing global currency regime, that of US dollar denominated deposits, allows (authorised) commercial banks to create and destroy deposits, within the bounds of regulations, at their discretion.

When a loan is repaid deposits, that is money, are destroyed. Deposits are also destroyed when commercial banks sell securities held on their balance sheets.

For central banks to increase their share of asset creation, it is will require undertaking transactions directly with sectors other than the financial sector. This is where MMT would hand central banks greater control of the process of creating and destroying money. More on that anon.

What About QE?

Quantitative easing (QE) and other refinancing programmes initiated by the major central banks following the Global Financial Crisis created the illusion of liquidity. Illusion because these programmes did not inject liquidity into the real economy, rather they forestalled a cascading debt default and asset impairment cycle in a bid to restore confidence in the financial system.

That is central banks, a few exceptions aside, continued to transact with the financial sector and not directly with sectors from the non-financial economy. Moreover, regulations, commercial and competitive considerations and structures created by central banks, such as the reverse repo facility, meant that QE did not result in money flowing to main street. And as such did not result in central banks having a bigger role in the creation and destruction of money.

Money Creation ≠ Inflation

“During 1870-1910, the decades of dynamic expansion, German government bond yields were actually declining. German yields did not decline as far as did British, Dutch, and French yields but were low enough to suggest that the savings of the people were keeping up with the financing requirements of a fast-growing economy. Germany was enjoying the benefits of that mighty weapon, a smooth annual accrual of new savings seeking investment in interest bearing securities. In the years before 1914, German bond yields were similar to yields in the United States, another large and fast-growing nation during the period 1870-1914.” ― A History of Interest Rates, Sidney Homer and Richard Sylla

If liquidity and money creation occurs in tandem with a growing productive capital base in the economy, money creation does not lead to inflation rather it contributes to rising living standards.

If money is created to sustain zombie companies or to avoid the mothballing of excess capacities, it drives down returns on invested capital. Declining returns eventually unleash deflationary forces as an increasing portion of debt in the system becomes unsustainable without ever increasing policy intervention. Simply put, deflation is the market’s signal for discouraging investment into additional capacities and an attempt to stoke consumption.

Inflation, the bad kind, occurs when continued policy intervention and money creation precipitates a loss of confidence in the central bank and eventually the currency. Credibility cannot be measured explicitly but we know the US has a lot more of it than, say, Argentina. It is this credibility that even allows a policy such as MMT to warrant a serious discussion in the US.

MMT: The Nuts & Bolts

Put simply, MMT is the recognition that government spending is not constrained by either taxation or its ability to borrow — at least not if the government has monetary seigniorage without the obligation to maintain a fixed exchange rate, whether against gold or another fiat currency. In these terms, the US federal government is not constrained, but the governments of European Monetary Union member states, say, or the Republic of Panama, are.

For governments meeting the above conditions, proponents of MMT advocate that policymakers can, nay should, create and spend as much money as necessary to achieve full employment and a targeted rate of inflation. Be it through the manipulation of aggregate demand or funding public healthcare or a universal basic income. If this entails running ever increasing fiscal deficits or devaluing the country’s currency, so be it.

Advocates of MMT only recognise resource constraints as limitations on a government’s ability to run larger and larger fiscal deficits. Take labour, for example. The government can pay public employees as much as it wants but it cannot employ more people than exist. The MMT framework also proposes that government spending should only focus on areas where it can utilise resources more efficiently than the private sector, otherwise there will be opportunity costs. Sticking with the case of labour, the MMT framework would encourage government to limit public sector employment to the extent that it does not draw employees from the private sector into the public sector.

Focus Should be on the Path, Not the Endgame

Most discussions on MMT devolve into either how it spells the end of the US dollar, or fiat currencies in general, or how it will spur uncontrollable inflation and therefore one must own gold or bitcoin or both. With time these proclamations may prove correct. The thing about capital markets, however, is that for the most part it is the path not the endgame that matters.

And as far as the path is concerned, it is not unreasonable, in our opinion, that initially MMT reinforces deflationary not inflationary forces. That is, by opening up the monetary spigots policymakers continue to keep cost of capital artificially suppressed thereby further delaying the inevitable impairment of excess capacities, zombie companies and unproductive debts. Ever increasing advantages would then continue to accrue to large companies, with access to low cost capital, at the expense of small and medium enterprises, further compounding the issues of inequality and declining productivity. Such a deflationary death spiral is what, we think, precipitates the endgame, not a sudden burst of inflation.

Clustered Volatility and the “Momentum Massacre”

“But, as with markets, in the ocean the interesting things happen not at the equilibrium sea level which is seldom realized, they happen on the surface where ever-present disturbances cause further disturbances. That, after all, is where the boats are.” ― W. Brian Arthur

Financial markets exhibit a temporal phenomenon known as clustered volatility. That is, the existence of periods of low volatility followed by periods of high volatility. Low volatility reigns supreme when the the outcome of the cumulative actions of market participants mutually benefits the majority. And, by extension, reaffirms the confidence the majority of market participants have in their forecast, “investment process”, algorithm or “analytical framework” ― or, more crudely, heuristics that they use in making their trading or investment decisions. The majority continue to follow their “process” and among the minority that did not benefit in the run up all but the most stubborn gradually adapt their processes to implicitly or explicitly chase momentum. Low volatility begets low volatility.

High volatility often occurs when an external agent, such as President Trump tweeting about tariffs or the People’s Bank of China excessively tightening or loosening financial conditions, disrupts the seeming equilibrium in the market. All else being equal, which it never is, the impact of external agents on market volatility, however, tends to be fleeting. For example, the declining half-life of President Trump’s trade war related tweets impact on the US equity market.

A structural change in volatility generally occurs when some participants or a group of market participants alter their algorithm ― such as shifting from selling at the money puts to deep out of the money puts ― or investment process or by the entry of entirely new participants with a novel agenda ― like the Bank of Japan buying up ETFs as part of its QE programme ― to the market.

The changing of algorithms or processes may, of course, be in response to the actions of external agents or the impact said actions had on the market. Regardless, this “updating” allows the first movers to front-run or anticipate the behaviour of the majority, which in turn causes other investors to re-adapt. This adaptive behavior, if it successfully percolates and propagates, moves the market away from its seeming equilibrium and into a state of ‘chaos’. It is this process of re-adapting that tends to precipitate longer lasting bouts of higher volatility.

Robert F. Engle, the winner of the Nobel Prize in Economics in 2003, formally defined this process of random periods of low volatility alternating with high volatility in financial markets as the the generalised autoregressive conditional heteroskedasticity (GARCH) process. (Heteroskedasticity is where observations do not conform to a linear pattern. Instead, they tend to cluster.)

Momentum Massacre

From the Financial Times on 12 September 2019 (emphasis added):

“The stock market may appear tranquil again after a rollercoaster summer, but many analysts and investors are unnerved by violent moves beneath the surface, reviving memories of the 2007 “quant quake” that shook the computer-driven investment industry.

The FTSE All-World equity index has rallied almost 3 per cent already this month, clawing back some of August’s losses. However, many highly popular stocks suffered a sudden and brutal sell-off this week, a reversal that analysts have already dubbed the “momentum crash”.

The blow was particularly strong in the US, where strong-momentum stocks — those with the best recent record — tumbled 4 per cent on Monday, in the worst one-day performance since 2009, according to Wolfe Research. Only once before, in 1999, has such a rout afflicted momentum-fuelled smaller company stocks, according to investment bank JPMorgan.”

This is massive,” said Yin Luo, head of quantitative strategy at Wolfe Research. “This is something that we haven’t seen for a long time. The question is why it’s happening, and what it means.”

The flipside has been a dramatic renaissance for so-called “value” stocks — out-of-favour, often unglamorous companies in more economically sensitive industries. The S&P value index has climbed about 4 per cent this week and, compared with momentum stocks, enjoyed one of its biggest daily gains in a decade on Monday.

The chart below is the ratio of the S&P Growth index to the S&P Value index. We are struggling to find the “dramatic renaissance”.

SGX Index (S&P 500 Growth Index) 2019-09-18 16-41-52.jpg

Of course we are being more than a bit flippant. Nonetheless, we do not think it is time to completely drop momentum or growth stocks and load up on value stocks. Rather we think the market is in a transient phase where participants are updating their algorithms and processes to go beyond momentum.

Our prescription from June remains valid:

We are increasingly convinced that a barbell strategy should be applied today in managing equity exposures. With tech and other growth names on one side and value names and precious metals on the other. And if tech and growth continue to rally, investors should re-balance regularly to avoid any lopsidedness in their portfolios.

The above has worked well in the recent “momentum massacre” and can continue to work well as long as uncertainty remains high and sentiment viciously waxes and wanes between optimism and pessimism. A slight adjustment to the above, however, is warranted as follows:

A barbell strategy should be applied today in managing equity exposures. With tech and other growth names on one side and value names and ~~precious metals~~ energy plays on the other.

Do Not Drop Momentum ― Not Completely Anyway

Dropping momentum or growth completely would be akin to calling the end of the transition away from actively managed portfolios to passively managed allocations that has accelerated since the Global Financial Crisis. Passive allocations are implicitly momentum seeking strategies. A strong secular trend is not upended by a 4 per cent move, it will take a crisis or a severe re-think of strategic asset allocation by the managers of the largest pools of capital to bring about an end to the trend.

The rise of passive investing, along with systematic volatility selling strategies, has contributed to the dampening of volatility since the Global Financial Crisis. A growing share of passive allocations, however, is somewhat like increasing leverage. As passive flows now make up the lion’s share of capital market flows, the actions of active investors are spread over a smaller segment of the investment universe. As the size of the active universe shrinks, in terms of what could be described as, in the case of stocks, free float market capitalisation minus passive allocations, the actions of active investors begin to have an exaggerated impact and give rise to higher volatility.

Simply put, the passive flows versus volatility curve is convex. Initially, increasing passive flows dampen volatility but beyond some hitherto unknown level increasing passive flows lead to higher volatility.

Why Energy Over Precious Metals?

Without delving into the geopolitics of it, the attacks on the Saudi Arabian oilfield should remind major oil consumers ― airlines, refiners, transportation companies and emerging economies such as India and China ― to review their energy security and hedging strategies. To balance future energy needs and to not become hostage to a rising geopolitical risk premium in the price of oil. This should lead to a rise in demand for oil at the margin; commodity prices are, of course, set at the margin.

The other angle is that if anything is going to take down the almighty bond bull market its going to be either: (1) fiscal spending by the G-7 governments of the like that we have never seen; or (2) a sharp and sustained increase in oil prices.

Lastly on energy, if Iran is, rightly or wrongly, shown to be the perpetrator of the attacks, China may have to reconsider it decision to purchase Iranian oil.

Confusing the Cyclical with the Secular | The Iran-China Strategic Partnership

“The reason a lot of people do not recognize opportunity is because it usually goes around wearing overalls looking like hard work.” ― Thomas Edison

“The most important lesson I’ve learned is to understand and to trust abstractions. If you can learn both to see and to believe in life’s underlying patterns, you can make highly informed decisions every day.” ― Nathan Myhrvold, former Chief Technology Officer of Microsoft

Confusing the Cyclical with the Secular

We have, since late last year, been bullishly positioned in precious metals and have reiterated this view on several occasions over the course of this year. That being said, however, we are not of the view that precious metals have entered a new secular bull market and will be making a run for new highs, in US dollar terms, in the near term.

Similarly, in last week’s piece, we highlighted cyclical factors indicating that long-term US bond yields were likely to rise, in the near-term, as opposed to going even lower. Once again, this is a cyclical, not a secular, view.

Below we share two passages that provide a framework for understanding the conditions that would lead to a bond market rout and a new secular bull market in precious metals.

The following passage in an excerpt from The Invisible Hands: Top Hedge Fund Traders on Bubbles, Crashes, and Real Money on the discussion between the author, Steven Drobny, and his (unrelated) colleague at Drobny Global Advisors, Dr. Andres Drobny (emphasis added):

Many people think there is a limit on public debt, but I am not so sure. Apart from a country constrained by a gold standard or fixed exchange rate, the only scenario where the government might bot be able to fund its debt is an inflationary scenario. However, the scenario only seems likely to emerge after the policies succeed in promoting growth. One of the reasons that a much-anticipated financing problem has never materialized in Japan is that reflationary policies failed to stimulate a sustained rebound and a return of inflation. Interest rates have remained low and fund the deficit has been surprisingly easy.

Consider what happens if the public debt and financing fears prove correct and bond markets start to tank. This is an issue that came up during a debate at our recent conference in London. Without inflation, rising nominal bond yields push up real yields and deflate the economy; bonds become more attractive again and buyers bring yields back down. Without inflation, it is hard to get a bond rout. It is only when inflation rises that government financing becomes a real and sustained problem for bond markets. That is when bonds no longer get cheaper as they sell off and nominal yields rise, which is when you get a real bond crisis.

The key takeaway from the above passage is that a secular turn in the bond market will only occur when rising nominal yields do not translate into rising real yields, that is when the rate of inflation outpaces the increase in nominal yields.

RR10CUS Index (Real 10 Year Yiel 2019-09-11 15-57-15.jpg

In the 1960’s and from the mid-1970’s through the early 1980’s, rising nominal yields in the US coincided with sharply declining real yields. Until such a disconnect begins to manifest, the secular bull market in bonds is intact.

The following passage in an excerpt from Peter Warburton’s essay The debasement of world currency: It’s inflation but not as we know it (emphasis added):

An excessive expansion of credit can create an environment where the factors of production — land, capital and labour services — appear to be in infinite supply. If sufficient (borrowed) financial resources are made available, then sterile, parched and polluted land can be fertilized, irrigated, cleaned up and turned to productive use. Similarly, more factories, kilns, assembly lines, steel mills, semiconductor plants and so on can be built using state-of-the-art technology. Idle and untrained workforces can be mobilized and organized into productive units. A rich country, with plenty of collateral assets against which to borrow, can indeed face a supply curve that is seemingly infinitely elastic. I can assure you that consumer price inflation will not be a problem for such an economy.

The United States still has plenty of collateral assets to borrow against. The US dollar hegemony may be on its last legs but there is no credible alternative making it still too early to bet against it.

BBDXY Index (Bloomberg Dollar Sp 2019-09-11 17-08-03.jpg

In the chart above, the magenta line is a custom index tracking the relative performance of US liquid assets (equities and investment grade bonds) to that of global liquid assets ex-US. The orange line is the Bloomberg Dollar Index ― the index is broader than $DXY, which is just a proxy for the EURUSD cross.

The continued out performance of US capital markets relative to the capital markets of the rest of the world is supportive of the US dollar and indicative of the superiority of US collateral relative to ex-US collateral.

The Iran-China Comprehensive Strategic Partnership

Speaking of the end of the US dollar hegemony, it was reported last week that Iran’s foreign minister Mohammad Zarif paid a visit to his Chinese counterpart Wang Li at the end of August to present a road map for the China-Iran comprehensive strategic partnership, signed in 2016.

As part of the deal, China will invest US dollars 280 billion in developing Iran’s oil, gas and petrochemicals sectors. There will be a further US dollars 120 billion of investments made by China in upgrading Iran’s transport and manufacturing infrastructure. Notably, the deal also includes “5,000 Chinese security personnel on the ground in Iran to protect Chinese projects, and […] additional personnel and material available to protect the eventual transit of oil, gas and petchems supply from Iran to China, where necessary, including through the Persian Gulf,” according to Iranian sources.

According to reports, the deal also includes a long-term commitment by China to buy Iranian oil. Based on these reports, Iran has agreed to sell its oil and gas to China at a guaranteed discount to prevailing market prices of at least 12 per cent, plus a further discount of up to 8 per cent to account for the risk ― presumably of a backlash from the US. China, of course, will pay for the oil in renminbi.

The benefits of the deal for Iran are obvious. It receives much-needed foreign direct investment. It secures a market for its hydrocarbon output. And secures a deterrent against possible military strikes by Israel or Saudi Arabia and its allies. Iran, though, does not simply want to be China’s discount oil dealer. It wants more, it wants a strategic alliance. Iranian foreign minister Mohammad Zarif penned an op-ed in the Global Times clearly articulating what Iran wants. It is unclear, however, if they will get it by “looking east”.

The benefits to China are somewhat mixed. Cheaper energy imports paid for not in US dollars but in local currency eases China’s dependence on the greenback and furthers its ambitions to form an independent monetary bloc. Buying Iranian oil and defying of US sanctions, on the other, is only likely to infuriate President Trump and further complicate ongoing trade negotiations.We see China’s willingness to defy US sanctions as a signal that its leadership is unwilling to do a deal with President Trump that it does not deem to be fair. By agreeing to buy Iranian oil, China is either hedging itself and preparing for a new economic reality or it is posturing to show strength in its negotiations with the US.

Aside from trade, the most interesting near term takeaway from China’s agreement to buy Iranian oil is that it did not lead to sharp pullback in the price of oil. Rather oil has moved higher, suggesting oil could move higher still.

The Cyclical and the Secular

“By searching the sky now, me and other asteroid hunters hope to give us the early warning – ideally decades – that we need. But that strategy of focused searching hasn’t stopped people from thinking about what we might do if an asteroid was on its way toward us.” ― Carrie Nugent

This week’s piece is both a bit short and important. In the second half of the piece, we share a critical identity in understanding the fundamental drivers of the US yield curve.

We have put in much time and thought into better understanding the economic fundamentals driving the yield curve and put forth a seemingly straightforward identity that, we hope, can better explain shifts in the yield curve.

OECD Leading Indicators and the Cyclical Trend

The below chart is that of the year-over-year change in the OECD Leading Indicator Index for major economies and that of the yield on the US 10-year Treasury bonds lagged by 3 months.

OECD LI vs 10Y Yield

The leading indicators index tends to lead long-term yields by, approximately, three months.

In 2018, long-term yields over shot to the upside based on the leading indicators index. Today, the index is signaling that yields are too low and on a cyclical basis economic activity in the major economies has bottomed and is turning up.

The below chart is that of the leading indicators index versus the the MSCI All Cap World Index excluding US stocks lagged by nine months. Global stocks, excluding the US, tend to lag the leading indicators index by six to nine months.

ACWI ex Us vs OECD LI.png

The leading indicators index suggests that non-US stocks are close to bottoming on a cyclical basis.

The Secular Trend Behind the Yield Curve

In the below chart, the orange line is the 10Y – 2Y US Treasury yield curve and the magenta line represents US private savings less US private investment.

US Savings Less Investment vs Yield Curve.png

Private savings less private investment approximates the shape of the yield. Given, however, the fractional reserve system of banking, the private savings surplus or deficit has some slippage that does not capture excess credit creation by the banking system. Nonetheless, it is a good enough proxy for the purposes of approximating the direction of the yield curve.

What does a private savings surplus or deficit have to do with yield curve?

At the start of an economic expansion, private savings are plentiful, having been replenished following a recession as households and corporations repair their balance sheets by increasing savings and scaling back investments. As private sector balance sheets are repaired, confidence slowly returns and a new investment cycle commences.

With plentiful savings, in the form of deposits and cash like holdings, short-term interest rates are pressured lower. Reduced appetite to invest in longer maturity assets following a recession pushes up longer-term interest rates to entice savers to invest in longer duration assets. With an upward sloping yield curve, the banking system is incentivised to undertake maturity transformation by borrowing short and lending long.

As savings are drawn down, the declining supply of capital at the short end of the yield curve places upward pressure on short-term interest rates. At the same time as capital moves towards longer duration assets, the increased supply pushes down interest rates at the long-end. The continued maturity transformation undertaken by banks by borrowing short and lending long eventually leads to a flattening of the yield curve.

The yield curve inverts when increasing investments have exhausted private sector savings and the competition for marginal capital available at the short-end pushes up short-term interest rates.

The yield curve eventually steepens as appetite for longer duration investments collapses and an increasing number of investments made during the expansion become impaired. Impairments are caused by (1) investments no longer being profitable (on a net present value basis) due to the higher short-term rates; or (2) revelations of misallocation of capital into speculative or ponzi investments that sustained only because of the abundance of capital.

The drop in capital investments precipitates a recession and the economy once again has to enter a phase of balance sheet repair before the economy re-enter an expansionary phase.

Economic Identities

(1) GDP (Y) = Consumption (C) + Government Spending (G) + Investment (I) + Exports (EX) – Imports (IM)

(2) Y – C – Tax (T) = G – T + I + EX – IM

(3) Private Savings (PS) = Y – C – T.

(4) PS = G – T + I + EX – IM

Current Account (CA) = EX – IM

(5) Savings of the Government (SG) = T – G

(6) PS = I + CA – SG

Putting It Altogether

Private sector savings in the US can be replenished by (1) increased foreign investment into the US, (2) the current account going from a deficit to a surplus or (3) the government increasing its spending.

If we assume, the current account deficit remains around current levels, private savings will only be replenished through increased (foreign) investment or increased government spending.

Loosely, government spending and foreign investment are two sides of the same coin. The US has historically financed its fiscal deficits with the capital foreigners have invested in US Treasury securities. Foreign investors, however, may be unable or unwilling to finance the US government for a wide variety of reasons including:

(1) a US dollar shortage leading to stress or turmoil in their local economies;

(2) protectionist policies of the Trump Administration; or

(3) the unfavourable risk-to-reward profile of financing ever increasing deficits at record low interest rates.

If all foreign investors want or need is higher carry, the yield curve will simply steepen as it has done in the past. In the no-longer remote chance that foreigners are unable or unwilling to finance growing US deficits for reasons other than higher carry, however, what then is the release valve that will enable private sector savings to be replenished?

Should we be surprised that modern monetary theory (MMT) has become part of the broader economic policy discussions and no longer a fringe theory?

MMT is a whole other can of worms and deserves a discussion on its own that we will return to at a more opportune time.