Financial Misery and the Flattening Yield Curve

 

“Every day is a bank account, and time is our currency. No one is rich, no one is poor, we’ve got 24 hours each.” – Christopher Rice, bestselling author

 

“He tried to read an elementary economics text; it bored him past endurance, it was like listening to somebody interminably recounting a long and stupid dream. He could not force himself to understand how banks functioned and so forth, because all the operations of capitalism were as meaningless to him as the rites of a primitive religion, as barbaric, as elaborate, and as unnecessary. In a human sacrifice to deity there might be at least a mistaken and terrible beauty; in the rites of the moneychangers, where greed, laziness, and envy were assumed to move all men’s acts, even the terrible became banal.” – Excerpt from The Dispossessed by Ursula K. Le Guin

 

“A bank is a place that will lend you money if you can prove that you don’t need it.” – Bob Hope

 

Before we get to the update, just a quick comment on the New York Times op-ed “I Am Part of the Resistance Inside the Trump Administration” written by a hitherto anonymous member of the Trump Administration, which we suspect many of you have already read. Our reaction to the piece is that an “elite” politician issuing an editorial in a highbrow broadsheet and talking of resistance against the President is far more likely to stoke populism than to weaken it. Moreover, as angry as President Trump may appear to be about the editorial on television, it gives him just the kind of ammunition he needs to drum up the “us against them” rhetoric and rouse his core supporters to turn up to vote during the forthcoming mid-term elections.

Moving swiftly on, this week we write about US financials.

 

Financials have not had a great year so far. The MSCI US Financials Index is up less than one per cent year-to-date, tracking almost 7 per cent below the performance of the S&P500 Index. While the equivalent financials indices for Japan and Europe are both down more than 11 per cent year to date.

At the beginning of the year, investors and the analyst community appeared to be positive on the prospects for the financial sector. And who can blame them? The Trump Tax Plan had made it through Congress, the global economy was experiencing synchronised growth, progress was being made on slashing the onerous regulations that had been placed on the sector in the aftermath of the global financial crisis, and banks’ net interest margins were poised to expand with the Fed expected to continue on its path of rate hikes.

 

So what happened?

We think US financials’ under performance can in large part be explained by the flattening of the US yield curve, which in turn can result in shrinking net interest margins and thus declining earnings. The long-end of the US yield curve has remained stubbornly in place, for example 30-year yields still have not breached 3.25 per cent, and all the while the Fed has continued to hike interest rates and pushed up the short-end of the curve.

 

Why has the long-end not moved?

There are countless reasons given for the flattening of the yield curve. Many of them point to the track record of a flattening and / or inverted yield curve front running a recession and thus conclude with expectations of an imminent recession.

The Fed and its regional banks are divided over the issue. In a note issued by the Fed in June, Don’t Fear the Yield Curve, the authors conclude that the “the near-term forward spread is highly significant; all else being equal, when it falls from its mean level by one standard deviation (about 80 basis points) the probability of recession increases by 35 percentage points. In contrast, the estimated effect of the competing long-term spread on the probability of recession is economically small and not statistically different from zero.”

Atlanta Fed President, Mr Raphael Bostic, and his colleagues on the other hand see “Any inversion of any sort is a sure fire sign of a recession”. While the San Francisco Fed notes that “[T]he recent evolution of the yield curve suggests that recession risk might be rising. Still, the flattening yield curve provides no sign of an impending recession”.

Colour us biased but we think the flattening of the yield curve is less to do with subdued inflation expectations or deteriorating economic prospects in the US and far more to do with (1) taxation and (2) a higher oil price.

US companies have a window of opportunity to benefit from an added tax break this year by maximising their pension contributions. Pension contributions made through mid-September of this year can be deducted from income on tax returns being filed for 2017 — when the U.S. corporate tax rate was still 35 per cent as compared to the 21 per cent in 2018. This one-time incentive has encouraged US corporations to bring forward pension plan contributions. New York based Wolfe Research estimates that defined-benefit plan contributions by companies in the Russell 3000 Index may exceed US dollars 90 billion by the mid-September cut-off – US dollars 81 billion higher than their contributions last year.

US Companies making pension plan contributions through mid-September and deducting them from the prior year’s tax return is not new. The difference this year is the tax rate cut and the financial incentive it provides for pulling contributions forward.

Given that a significant portion of assets in most pension plans are invested in long-dated US Treasury securities, the pulled forward contributions have increased demand for 10- and 30-year treasuries and pushed down long-term yields.

Higher oil prices, we think, have also contributed to a flattening of the yield curve.

Oil exporting nations have long been a stable source of demand for US Treasury securities but remained largely absent from the market between late 2014 through 2017 due to the sharp drop in oil prices in late 2014. During this time these nations, particularly those with currencies pegged to the US dollar, have taken drastic steps to cut back government expenditures and restructure their economies to better cope with lower oil prices.

With WTI prices above the price of US dollars 65 per barrel many of the oil exporting nations are now generating surpluses. These surpluses in turn are being recycled into US Treasury securities. The resurgence of this long-standing buyer of US Treasury securities has added to the demand for treasuries and subdued long-term yields.

 

Investment Perspective

 

A question we have been recently asked is: Can the US equity bull market continue with the banking sector continuing to under perform?

Our response is to wait to see how the yield curve evolves after the accelerated demand for treasuries from pension funds goes away. Till then it is very difficult to make a definitive call and for now we consider it prudent to add short positions in individual financials stocks as a portfolio hedge to our overall US equities allocation while also avoiding long positions in the sector.

We have identified three financials stocks that we consider as strong candidates to short.

 

Synovus Financial Corp $SNV 

 

SNV

 

Western Alliance Bancorp $WAL

 

WAL 

Eaton Vance Corp $EV

 

EV

 

 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. 

The Case for a Pickup in US Inflation

“Given the right economic conditions, business will make substantial efforts to train workers. When the economy is moving along at a healthy pace and firms are eager to hire additional personnel, individuals with few qualifications begin to find opportunities.”

“Labor is the largest cost of the business sector. It has two determinants: employee compensation rates and worker productivity. When employee compensation rates increase, labor costs increase. When worker productivity increases, business pays less to get a job done. Both rising compensation rates and stagnating productivity in the United States have made critical contributions to inflation.”

– Excerpts from Profits and the Future of American Society, S Jay Levy and David A. Levy (1983)

 

“[I]nflation will remain rather limited as long as bad money, here the vellon, is still driving out the good silver money. For this means that the total money supply is scarcely changing.”

“[U]nexpected reversals of monetary policy seem to be the rule, especially when inflation accelerates, and if uninformed rulers try to react to consequences not foreseen by them. As a consequence, one can expect no damage from inflation in the real economy only as long as it remains small and smooth.”

– Excerpts from Monetary Regimes and Inflation, Peter Bernholz (2003)

 

Inflation principally comes in one of two forms:

  • Rising resource prices; or
  • Wage growth outpacing productivity growth.

Given the services-biased structure of the US economy, wage growth outpacing productivity growth has a far greater and more sustainable impact on US inflation than do rising resource prices. With wage growth in structural decline, inflation has remained tepid in the US despite the best efforts of policymakers.

Services as a Share of GDPServices ShareSource: The World Bank

During the recent Fed meeting, the Federal Open Market Committee downgraded its 2017-18 inflation forecasts lower. Despite this, Fed Chair Yellen argued that weak pricing pressures are transitory. We are in agreement with Janet Yellen and find that US inflation is on the cusp of turning sustainably higher.

To assess the prospects of US inflation on a look forward-basis we analyse the relationship between inflation, wage growth and productivity growth. As proxies, we use the annual change in US CPI for urban consumers to represent inflation, the US unit labour costs for the nonfarm business sector to represent wages and US output per hour for all persons for the nonfarm business sector as a measure of productivity.

Comparing inflation to wage growth less productivity growth, we find the relationship to have moderately positive correlation. The R-squared using quarterly data from Q4 1997 to Q2 2017 is 0.52. This relationship is much stronger during periods the two measures are trending, either positively or negatively.

Change in the Consumer Price Index vs. Wage Growth less Productivity GrowthCPI vs WG less PGSources: Bureau of Economic Analysis, Bureau of Labor Statistics

The differential between wage growth and productivity growth has been trendless since 2011, swinging from negative to positive and back on an almost quarterly basis. No wonder then that the inflation environment has remained benign, much to the frustration of the Fed, who has pulled out all the stops to fight deflationary tendencies within the economy.

Despite the seeming absence of inflation, we find that inflationary forces have been gathering steam since 2014. This has failed to show up in the headline data due to the outsized impact of a handful of industries caught up in downturns.

Based on data provided by the Bureau of Labor Statistics, wage growth has outpaced productivity growth across a majority of industries from 2014 through 2016. However, workers in the oil and gas extraction, media related and retail focused industries have suffered from declining wages and this has kept a lid on overall wage growth.

Annualised Wage Growth less Productivity Growth by Industry (2014 to 2016)WG less PG IndustrySource: Bureau of Labor Statistics

As the base effects of the negatively impacted industries unwind, we fully expect, headline inflation measures to turn up and begin to exceed consensus expectations. Giving further credence to our assertion is the tightness in the US labour market. The jobs opening rate and the number of small businesses identifying job opportunities as hard to fill are either at or near their highest levels since the turn of the century. At the same time, US U-3 unemployment is at its lowest level since 2000.

US Jobs Opening RateUS Job Openings RateSource: Bureau of Labor Statistics

 US Small Business Job Openings Hard to FillJobs hard to fillSource: National Federation of Independent Business

US U-3 Unemployment RateUS UnemploymentSource: Bureau of Labor Statistics

Historically, periods of labour market tightness when businesses are facing difficulty in filling job openings have preceded increasing wage growth. Comparing the US Small Business Job Openings Hard to Fill index to US wage growth lagged by one year, we find this to be the case up until the end of 2012. Since 2013, however, the relationship appears to no longer hold true. The number of businesses reporting job opportunities difficult to fill has been increasing while wage growth has remained largely absent.

Small Business Job Openings Hard to Fill vs. Wage Growth (Lagged One Year)Job Openings vs WGSources: Bureau of Labor Statistics, National Federation of Independent Business

Once again, the relationship is seemingly impaired at the headline level due to the outsized impact of a handful of industries. Based on data provided by the Bureau of Labor Statistics, wage growth has been positive across a majority of industries from 2014 through 2016. The oil and gas extraction industry, unsurprising given the collapse in the price of oil in 2014, has been a major drag on overall wage growth.

Annualised Wage Growth by Industry (2014 to 2016)Wage Growth IndustrySource: Bureau of Labor Statistics

Going forward, the oil and gas extraction industry should no longer be a drag on headline wage growth and may even have a positive impact on it if oil prices continue to increase. We therefore expect wage growth to pick up as businesses increasingly pay up or hire lower skilled labour and train them up to fill outstanding job openings.

Small Business Job Openings Hard to Fill vs. Capital Expenditure PlansJobs hard to fill vs Capex PlansSource: National Federation of Independent Business

The effects of the structural deflationary forces of globalisation, migration / labour mobility and declining trade union membership are also abating. The lion’s share of gains from outsourcing has already been realised. Politicians are increasingly pandering to populous movements and turning to protectionist policies, making labour migration far less frictionless. Trade unions have held very little appeal to younger workers that entered the workforce in recent years.

The inevitable corollary is the rising labour share of corporate profits will place increasing pressure on businesses to improve productivity. We therefore expect capital expenditures to pick up. Businesses will increasingly invest in automation and robotics to overcome the challenges of wage inflation and labour market tightness.

Small Business Capital Expenditure Plans vs. Productivity Growth (Lagged One Year)Capex plavs vs PGSources: Bureau of Labor Statistics, National Federation of Independent Business

Increased corporate spending will not only lead to improvements in productivity but to an upturn in the overall US business cycle. Capital investment has been the one missing ingredient in the US economic recovery since the Global Financial Crisis.  As businesses spend more, corporate profitability will pick up, which will lead to increased hiring and higher wages, which will feed into further investments into automation and robotics.

Our base case is, therefore, that the current US economic expansion will be the longest ever recorded. And the business cycle will only come to a turn after unemployment levels fall below 4%, inflation exceeds prevailing expectations and policymakers begin to respond to the unexpected consequences.

 

Investment Perspective

US median household income has been rising and we expect it to continue to rising as wage growth accelerates.

US Median Real Household IncomeUS Median Household IncomeSource: US Census Bureau

At the same time, US household balance sheets have been repaired with the household debt to disposable income ratio in decline since the Global Financial Crisis. More so, the debt service to disposable income ratio is at comfortable levels for US households. There is ample room for households to take on more debt, especially for the poorest households who are the likeliest to benefit as wage growth picks up.

US Household Debt to Disposable IncomeUS Household debt to disposable incomeSource: Bloomberg

 US Household Debt Service RatioUS Household DSRSource: Bloomberg

As poorer households’ disposable income increases, this cohort is more likely to increase consumption as opposed to increasing savings, especially when compared to upper-middle and upper class households. Poorer households shop at Walmart not Whole Foods. They eat at McDonald’s not Shake Shack. We expect retailers and quick service restaurants catering to lower and lower-middle income households to be amongst the greatest beneficiaries of higher wages. We are particularly bullish on the prospects of Walmart ($WMT).

Consider the relationship between US wage growth and $WMT revenue growth lagged by one year. The revenue growth measure does not adjust for store openings, corporate actions and other extraordinary events that may have occurred during intervening periods. Despite the lack of adjustments, this dirty measure has shown a strong relationship with wage growth.

$WMT’s revenue growth has flat lined in recent years as wage growth has been trendless. As wage growth picks up, we expect investors to increasingly come to recognise $WMT’s growth potential and rotate out of Amazon and into $WMT.

US Wage Growth vs. Walmart Revenue Growth (Lagged One year)WMT vs WGSources: Bureau of Labor Statistics, Bloomberg

A derivative of accelerating wage growth and labour market tightness is business’ increasing investment in automation and robotics. We are at the beginning of a long-term secular trend towards automation. Rather than picking winners at this early stage in the trend, we recommend positioning in a basket of automation and robotics related companies. The most obvious way to play this theme is the ROBO Global Robotics and Automation Index ETF ($ROBO).

Lastly, another derivative of accelerating wage growth is that the Fed is likely to increase interest rates at a faster pace in 2018 than currently anticipated by the market. We expect the short end of the curve to rise faster than the long-end, resulting in a classic bear flattening.

US Wage Growth vs. Effective Federal Funds RateEffective FFR vs WGSources: Bureau of Labor Statistics, Bloomberg

We are long $WMT, $ROBO and looking to get short the short-end of the Treasury yield curve.