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. 

Industrial Commodities: A Sustainable Bull Market?

“We must not forget that housing is for living in, not for speculation. With this in mind, we will move faster to put in place a housing system that ensures supply through multiple sources, provides housing support through multiple channels, and encourages both housing purchase and renting. This will make us better placed to meet the housing needs of all of our people.”

– Excerpt from Xi Jinping’s speech at the 19th Communist Party of China National Congress

 

“Commodities tend to zig when the equity markets zag.” – Jim Rogers

 

“Let the market, not politicians, determine the flow of rice, oil and other commodities. Lower, more stable prices will ensue.” – Steve Hanke, Co-Director of the Johns Hopkins Institute for Applied Economics, Global Health, and the Study of Business Enterprise

 

“Capital is money, capital is commodities. By virtue of it being value, it has acquired the occult ability to add value to itself. It brings forth living offspring, or, at the least, lays golden eggs.” – Karl Marx

 

Industrial metals have had a great run starting in late 2015 and early 2016; equities of industrial metal producers even more so. Given this rally and the uncertainties around the Chinese investment-led growth model, one of the more difficult investment questions we have struggled with is: whether this bull market in industrial metals is sustainable or not? Our analysis seems to suggest that it is.

Commodity Research Bureau (CRB) US Spot Raw Industrial IndexCRB

Source: Commodity Research Bureau

We have a fairly straightforward framework to help us develop our initial opinion on the outlook for industrial metals. The framework is centred on Chinese money supply metrics, both M1 and M2, and essentially functions as a heuristic for capital spending in China. Chinese capital spending, as is widely accepted, has been the primary driver of demand for industrial commodities over the last two decades.

As a part of this framework we monitor the dynamic between two measures of money supply, M1 and M2. As M1 is a more narrowly defined measure of money supply consisting of the most liquid components – such as physical cash, checking accounts and demand deposits – of overall money supply, any increase in M1 relative to M2 is indicative of a move away from saving and toward investment. For example, companies that hoard cash tend to hold it in the form of time deposits and other financial assets, should the need to make capital investments arise, they would have to unwind these financial investments. This unwinding of financial investments into cash results in M1 increasing while M2 remains unchanged. To monitor this dynamic we simply calculate the ratio of M1 to M2. A higher number means M1 is increasing relative to M2 while a low number means M1 is declining relative to M2.

The ratio of M1 to M2 has been increasing since the end of 2015, indicating a higher propensity to invest than to save in China.

  Ratio of China Money Supply M1 to China Money Supply M2M1 to M2 China

Source: The People’s Bank of China

While this ratio is informative during periods the ratio is trending, either upwards or downwards, it adds little value during periods it is stable, as witnessed between 1999 and 2007. In such periods, we rely, instead, on the year-on-year growth in M1. If M1 to M2 ratio is stable, then a growing M1 is indicative of an increase in the absolute level of investment in the economy.  As a rule of thumb, growth in China’s M1 has tended to manifest itself in higher industrial commodity prices 4 to 8 months down the line.

Chinese M1 increased rapidly between the end of 2015 and early 2017 but has started to decline since. So while this signals a decline in the rate of growth in investment, the metric remains positive. This combined with a higher propensity to invest over saving, as indicated by the M1 to M2 ratio, suggests that the level of investment in China should remain healthy during the first half of 2018 and support continued demand for industrial commodities.

CRB US Spot Raw Industrial Index vs. China M1 YoY Growth (Lagged 6 Months)M1 YoY China vs CRB Industrial Metals

Sources: The People’s Bank of China, Commodity Research Bureau

This framework has worked well as a timing tool for investing in industrial metals since the turn of the century. It may continue to work well, we suspect, as long as Chinese demand is the primary determinant of commodity prices. The limitation, however, is that the framework is purely Chinese demand centric and does not take into consideration substantial demand creation or destruction from other parts of the world; nor does it give weight to changing supply-side dynamics.

On the demand side, we think there are two key forces that will determine the trajectory of industrial commodities during 2018. The first is construction activity in China, ergo housing demand. While the second is the incentives within US tax bill for corporations to increase capital investment in the near term.

Xi Jinping in his speech at the Communist Party of China’s 19th National Congress addressed the need to “put in place a housing system that ensures supply through multiple sources”. To our mind this is as much to do with affordability as it is to do with the supply of housing, which is why Xi specifically mentioned encouraging renting as part of the solution.

Earlier in the year, the Chinese government announced that it will allow, on a trial basis, the development of rental housing projects on rural land – the trial will be conducted in 13 cities including Shanghai, Beijing, Guangzhou and Shenzhen. According to data from Centaline Property, 10 cities have already allocated land for rental housing construction. Chief amongst them is Beijing, where authorities expect to supply 6,000 hectares of land for residential housing by 2021, almost a third of which will be for rental housing. Beijing has even gone as far as announcing a new rental housing policy, which guarantees the same education rights to the children of the tenants of rental properties as the rights afforded to the children of property owner. The new policy even enables tenants renting government-subsidized housing to have their household registration (“hukou”) on their rented homes.

The government is clearly very serious about developing the rental housing market. And key private sector participants are responding to the government’s signals. Not long after the National Congress, China Construction Bank – one of the big four banks in China – launched a loan product for home renters.  China Vanke, a leading residential real estate developer in China, indicated that it aims to provide up to 100,000 apartments for long-term leases, up from the 24,000 rental units operated currently. AliPay, Alibaba’ mobile payment platform, announced that it would enable users across eight cities and based on their credit history to rent residential properties through the platform without having to pay deposits.

The Chinese government’s objective is to make housing more affordable. House prices in major cities have become exorbitantly high and this is a factor contributing to the dampening in the rate of Chinese urbanisation. If the government’s goal of transforming the Chinese economy into a consumption-led, as opposed to investment-led, economy is to be achieved, urbanisation needs to continue unabated for many more years. Simply because urban consumers clearly outspend rural consumers – after all, the Joneses do not live in rural China.

Despite the willingness shown by some of the large private sector developers at the early stage – it is not too difficult to nudge companies dependent on government largesse – the challenge for the government will be to create a system in which property developers are able to offload inventory to recoup their investment shortly after delivery, as opposed to collecting rents over many years. Solutions to this problem can involve mobilising capital from pension funds and other institutional investors into rental properties, developing capital market infrastructure to increase the number of real estate investment vehicles such as real estate investment trusts or other forms of securitisation, or simply facilitating increased investment by international real estate income funds into China.

Notwithstanding the challenges, the key point for us is that the Chinese government has a goal that ultimately creates an additional source of demand for housing and thus construction. This incremental demand can only be bullish for the demand for industrial metals.

The incentives for US capital investment created by the potential tax reform maybe somewhat more subtle than the overtures of the Chinese government but might ultimately prove to be as bullish, if not more, for industrial commodities. The key provisions in the tax bill in this regard are the:

  1. Corporate income tax rate being cut from 35 per cent to 21 per cent, effective 1 January, 2018
  2. Capital expensing provision that permits businesses to completely write-off, or expense, the entire value of investments in plant and equipment for five years. Starting the sixth year, this provision is gradually eliminated over a five year period

Cutting the corporate tax rate from 35 to 21 per cent is bound to increase investment into the US. On top of that, the capital expensing provision within the proposal incentivises both new capital that comes into the US as well as existing capital to be put into plant and equipment. At a time where companies are struggling to recruit adequately trained staff and productivity growth is non-existent, the capital expense provision is likely to result in a substantial increase in the demand for capital goods — and for industrial commodities.

Coming to supply, China’s supply side reforms are well documented – capacities at coal mines have been curtailed, steel mills have been shuttered and the supply of natural gas rationed. The results thus far have been largely positive.

 

Investment Perspective

 

Deflationary forces reward businesses that delay investment and maintain low levels of inventory. The lack of capital investment and the absence of excess levels of inventory, in turn reduces the risk of impairment, write-down or liquidation. Without write-downs or liquidation, the business cycle continues, albeit unimpressively. This has been the case since the Global Financial Crisis and especially after commodities peaked in 2011/12.

What if given the supply and demand dynamics, however, we are at the early stages of an industrial commodities bull market?  What if the depleted inventory levels combined with reduced production capacities leads to a feeding frenzy whereby rising prices result in rising demand? The latter is the very dynamic witnessed in the semiconductors market this year. And we certainly see it is a plausible, albeit low probability, scenario for industrial metals for 2018.

We are of the opinion, barring short-term volatility, the risk for industrial metals remains to the upside.

We are long Vale SA ($VALE) and United States Steel Corporation ($X). We will be looking to add other names and direct commodity plays on any meaningful pullbacks.  

 

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 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.