Consumers, businesses, and investors confronted a meaningful headwind in the second quarter of 2019—the risk of escalating trade tensions and their unintended consequences. This came to fruition when China was perceived to backtrack on agreements regarding changes it would make to its trade and domestic policies, bringing negotiations to a standstill. When the world learned of this development over social media, it was forced to reassess its expectations for trade and growth over the foreseeable future. The following two weeks saw the 10-year Treasury yield fall 13 basis points. The derailment of trade negotiations with China was shortly followed by the threat of U.S. tariffs on Mexican goods. Those threats came and went within a span of two weeks. News headlines also reminded readers that tariffs on European autos were a possibility. Markets moved on every development, causing a spike in the S&P 500 implied volatility and another sizable decline in U.S. Treasury yields as the market downgraded expectations for inflation and economic growth. Quarter over quarter, the 10-year Treasury yield fell almost 40 basis points. For now, the data do not suggest the United States will experience an imminent economic contraction. Our internal projections put second quarter real gross domestic product (GDP) growth around 2 percent, and we expect full-year 2019 real GDP growth (Q4/Q4) of around 2 percent. This is consistent with our recession dashboard, which continues to point to a recession starting sometime in 2020. Historically, a fed funds rate below the nominal GDP growth rate has been associated with an expanding economy. With the GDP deflator rising 1.9 percent year over year in the first quarter and real output expanding by 3.2 percent, nominal U.S. economic output rose by 5.1 percent. This would appear to put the Fed in a relatively accommodative monetary policy stance with overnight rates at 2.4 percent. The overnight rate has risen above nominal GDP growth before the start of the last three recessions. And while a decline in the natural rate of interest over time means that the economy will face pressure at lower levels of interest rates, the current federal funds rate is merely in line with the Federal Open Market Committee’s (FOMC) median estimate of neutral. Despite the lack of a restrictive Fed stance, over 100 basis points of cumulative easing is priced into fed funds futures between now and December 2020. Under normal circumstances, this aggressive easing would only be delivered by the Fed after it has shifted monetary policy into restrictive territory and left the U.S. economy vulnerable to shocks. But today, what ails the U.S. economy is not an overly restrictive Fed. Expectations have deteriorated because of volatile trade policy, U.S. political instability, fading fiscal stimulus, weak global growth, and clumsy Fed communication. If the U.S. economy has been misdiagnosed, Fed easing may be the wrong cure.
Ray Dalio writes in his LinkedIn Post https://www.linkedin.com/pulse/paradigm-shifts-ray-dalio/
One of my investment principles is:
Identify the paradigm you’re in, examine if and how it is unsustainable, and visualize how the paradigm shift will transpire when that which is unsustainable stops.
Over my roughly 50 years of being a global macro investor, I have observed there to be relatively long of periods (about 10 years) in which the markets and market relationships operate in a certain way (which I call “paradigms”) that most people adapt to and eventually extrapolate so they become overdone, which leads to shifts to new paradigms in which the markets operate more opposite than similar to how they operated during the prior paradigm. Identifying and tactically navigating these paradigm shifts well (which we try to do via our Pure Alpha moves) and/or structuring one’s portfolio so that one is largely immune to them (which we try to do via our All Weather portfolios) is critical to one’s success as an investor.
How Paradigm Shifts Occur
There are always big unsustainable forces that drive the paradigm. They go on long enough for people to believe that they will never end even though they obviously must end. A classic one of those is an unsustainable rate of debt growth that supports the buying of investment assets; it drives asset prices up, which leads people to believe that borrowing and buying those investment assets is a good thing to do. But it can’t go on forever because the entities borrowing and buying those assets will run out of borrowing capacity while the debt service costs rise relative to their incomes by amounts that squeeze their cash flows. When these things happen, there is a paradigm shift. Debtors get squeezed and credit problems emerge, so there is a retrenchment of lending and spending on goods, services, and investment assets so they go down in a self-reinforcing dynamic that looks more opposite than similar to the prior paradigm. This continues until it’s also overdone, which reverses in a certain way that I won’t digress into but is explained in my book Principles for Navigating Big Debt Crises, which you can get for free here.
Another classic example that comes to mind is that extended periods of low volatility tend to lead to high volatility because people adapt to that low volatility, which leads them to do things (like borrow more money than they would borrow if volatility was greater) that expose them to more volatility, which prompts a self-reinforcing pickup in volatility. There are many classic examples like this that repeat over time that I won’t get into now. Still, I want to emphasize that understanding which types of paradigms exist and how they might shift is required to consistently invest well. That is because any single approach to investing—e.g., investing in any asset class, investing via any investment style (such as value, growth, distressed), investing in anything—will experience a time when it performs so terribly that it can ruin you. That includes investing in “cash” (i.e., short-term debt) of the sovereign that can’t default, which most everyone thinks is riskless but is not because the cash returns provided to the owner are denominated in currencies that the central bank can “print” so they can be depreciated in value when enough money is printed to hold interest rates significantly below inflation rates.
In paradigm shifts, most people get caught overextended doing something overly popular and get really hurt. On the other hand, if you’re astute enough to understand these shifts, you can navigate them well or at least protect yourself against them. The 2008-09 financial crisis, which was the last major paradigm shift, was one such period. It happened because debt growth rates were unsustainable in the same way they were when the 1929-32 paradigm shift happened. Because we studied such periods, we saw that we were headed for another “one of those” because what was happening was unsustainable, so we navigated the crisis well when most investors struggled.
I think now is a good time 1) to look at past paradigms and paradigm shifts and 2) to focus on the paradigm that we are in and how it might shift because we are late in the current one and likely approaching a shift. To do that, I wrote this report with two parts: 1) “Paradigms and Paradigm Shifts over the Last 100 Years” and 2) “The Coming Paradigm Shift.” They are attached. If you have the time to read them both, I suggest that you start with “Paradigms and Paradigm Shifts over the Last 100 Years” because it will give you a good understanding of them and it will give you the evolving story that got us to where we are, which will help put where we are into context. There is also an appendix with longer descriptions of each of the decades from the 1920s to the present for those who want to explore them in more depth.
Note: I have only reproduced below the second paradigm
Part 2: The Coming Paradigm Shift
The main forces behind the paradigm that we have been in since 2009 have been:
Central banks have been lowering interest rates and doing quantitative easing (i.e., printing money and buying financial assets) in ways that are unsustainable. Easing in these ways has been a strong stimulative force since 2009, with just minor tightenings that caused “taper tantrums.” That bolstered asset prices both directly (from the actual buying of the assets) and indirectly (because the lowering of interest rates both raised P/Es and led to debt-financed stock buybacks and acquisitions, and levered up the buying of private equity and real estate). That form of easing is approaching its limits because interest rates can’t be lowered much more and quantitative easing is having diminishing effects on the economy and the markets as the money that is being pumped in is increasingly being stuck in the hands of investors who buy other investments with it, which drives up asset prices and drives down their future nominal and real returns and their returns relative to cash (i.e., their risk premiums). Expected returns and risk premiums of non-cash assets are being driven down toward the cash return, so there is less incentive to buy them, so it will become progressively more difficult to push their prices up. At the same time, central banks doing more of this printing and buying of assets will produce more negative real and nominal returns that will lead investors to increasingly prefer alternative forms of money (e.g., gold) or other storeholds of wealth.
As these forms of easing (i.e., interest rate cuts and QE) cease to work well and the problem of there being too much debt and non-debt liabilities (e.g., pension and healthcare liabilities) remains, the other forms of easing (most obviously, currency depreciations and fiscal deficits that are monetized) will become increasingly likely. Think of it this way: one person’s debts are another’s assets. Monetary policy shifts back and forth between a) helping debtors at the expense of creditors (by keeping real interest rates down, which creates bad returns for creditors and good relief for debtors) and b) helping creditors at the expense of debtors (by keeping real interest rates up, which creates good returns for creditors and painful costs for debtors). By looking at who has what assets and liabilities, asking yourself who the central bank needs to help most, and figuring out what they are most likely to do given the tools they have at their disposal, you can get at the most likely monetary policy shifts, which are the main drivers of paradigm shifts.
To me, it seems obvious that they have to help the debtors relative to the creditors. At the same time, it appears to me that the forces of easing behind this paradigm (i.e., interest rate cuts and quantitative easing) will have diminishing effects. For these reasons, I believe that monetizations of debt and currency depreciations will eventually pick up, which will reduce the value of money and real returns for creditors and test how far creditors will let central banks go in providing negative real returns before moving into other assets.
To be clear, I am not saying that this shift will happen immediately. I am saying that I think it is approaching and will have a big effect on what the next paradigm will look like.
The chart below shows interest rate and QE changes in the US going back to 1920 so you can see the two times that happened—in 1931-45 and in 2008-14.
The next three charts show the US dollar, the euro, and the yen since 1960. As you can see, when interest rates hit 0%, the money printing began in all of these economies. The ECB ended its QE program at the end of 2018, while the BoJ is still increasing the money supply. Now, all three central banks are turning to these forms of easing again, as growth is slowing and inflation remains below target levels.
2. There has been a wave of stock buybacks, mergers, acquisitions, and private equity and venture capital investing that has been funded by both cheap money and credit and the enormous amount of cash that was pushed into the system. That pushed up equities and other asset prices and drove down future returns. It has also made cash nearly worthless. (I will explain more about why that is and why it is unsustainable in a moment.) The gains in investment asset prices benefited those who have investment assets much more than those who don’t, which increased the wealth gap, which is creating political anti-capitalist sentiment and increasing pressure to shift more of the money printing into the hands of those who are not investors/capitalists.
3. Profit margins grew rapidly due to advances in automation and globalization that reduced the costs of labor.The chart below on the left shows that growth. It is unlikely that this rate of profit margin growth will be sustained, and there is a good possibility that margins will shrink in the environment ahead. Because this increased share of the pie going to capitalists was accomplished by a decreased share of the pie going to workers, it widened the wealth gap and is leading to increased talk of anti-corporate, pro-worker actions.
4. Corporate tax cuts made stocks worth more because they give more returns. The most recent cut was a one-off boost to stock prices. Such cuts won’t be sustained and there is a good chance they will be reversed, especially if the Democrats gain more power.
These were big tailwinds that have supported stock prices. The chart below shows our estimates of what would have happened to the S&P 500 if each of these unsustainable things didn’t happen.
The Coming Paradigm Shift
There’s a saying in the markets that “he who lives by the crystal ball is destined to eat ground glass.” While I’m not sure exactly when or how the paradigm shift will occur, I will share my thoughts about it. I think that it is highly likely that sometime in the next few years, 1) central banks will run out of stimulant to boost the markets and the economy when the economy is weak, and 2) there will be an enormous amount of debt and non-debt liabilities (e.g., pension and healthcare) that will increasingly be coming due and won’t be able to be funded with assets. Said differently, I think that the paradigm that we are in will most likely end when a) real interest rate returns are pushed so low that investors holding the debt won’t want to hold it and will start to move to something they think is better and b) simultaneously, the large need for money to fund liabilities will contribute to the “big squeeze.” At that point, there won’t be enough money to meet the needs for it, so there will have to be some combination of large deficits that are monetized, currency depreciations, and large tax increases, and these circumstances will likely increase the conflicts between the capitalist haves and the socialist have-nots. Most likely, during this time, holders of debt will receive very low or negative nominal and real returns in currencies that are weakening, which will de facto be a wealth tax.
Right now, approximately 13 trillion dollars’ worth of investors’ money is held in zero or below-zero interest-rate-earning debt. That means that these investments are worthless for producing income (unless they are funded by liabilities that have even more negative interest rates). So these investments can at best be considered safe places to hold principal until they’re not safe because they offer terrible real returns (which is probable) or because rates rise and their prices go down (which we doubt central bankers will allow).
Thus far, investors have been happy about the rate/return decline because investors pay more attention to the price gains that result from falling interest rates than the falling future rates of return. The diagram below helps demonstrate that. When interest rates go down (right side of the diagram), that causes the present value of assets to rise (left side of the diagram), which gives the illusion that investments are providing good returns, when in reality the returns are just future returns being pulled forward by the “present value effect.” As a result future returns will be lower.
That will end when interest rates reach their lower limits (slightly below 0%), when the prospective returns for risky assets are pushed down to near the expected return for cash, and when the demand for money to pay for debt, pension, and healthcare liabilities increases. While there is still a little room left for stimulation to produce a bit more of this present value effect and a bit more of shrinking risk premiums, there’s not much.
At the same time, the liabilities will be coming due, so it’s unlikely that there will be enough money pushed into the system to meet those obligations. Then it is likely that there will be a battle over 1) how much of those promises won’t be kept (which will make those who are owed them angry), 2) how much they will be met with higher taxes (which will make the rich poorer, which will make them angry), and 3) how much they will be met via much bigger deficits that will be monetized (which will depreciate the value of money and depreciate the real returns of investments, which will hurt those with investments, especially those holding debt).
The charts below show the wave of liabilities that is coming at us in the US.
*Note: Medicare, Social Security, and other government programs represent the present value of estimates of future outlays from the Congressional Budget Office. Of course, some of the IOUs have assets or cash flows partially backing them (like tax revenue covering some Social Security outlays). 10-year forward projections are based on government projections of public debt and social welfare payments.
*Note: Medicare, Social Security, and other government programs represent the present value of estimates of future outlays from the Congressional Budget Office. Of course, some of the IOUs have assets or cash flows partially backing them (like tax revenue covering some Social Security outlays). 10-year forward projections are based on government projections of public debt and social welfare payments.
History has shown us and logic tells us that there is no limit to the ability of central banks to hold nominal and real interest rates down via their purchases by flooding the world with more money, and that it is the creditor who suffers from the low return.
Said differently:
The enormous amounts of money in no- and low-returning investments won’t be nearly enough to fund the liabilities, even though the pile looks like a lot. That is because they don’t provide adequate income. In fact, most of them won’t provide any income, so they are worthless for that purpose. They just provide a “safe” place to store principal. As a result, to finance their expenditures, owners of them will have to sell off principal, which will diminish the amount of principal that they have left, so that they a) will need progressively higher and higher returns on the dwindling amounts (which they have no prospect of getting) or b) they will have to accelerate their eating away at principal until the money runs out.
That will happen at the same time that there will be greater internal conflicts (mostly between socialists and capitalists) about how to divide the pie and greater external conflicts (mostly between countries about how to divide both the global economic pie and global influence). In such a world, storing one’s money in cash and bonds will no longer be safe. Bonds are a claim on money and governments are likely to continue printing money to pay their debts with devalued money. That’s the easiest and least controversial way to reduce the debt burdens and without raising taxes. My guess is that bonds will provide bad real and nominal returns for those who hold them, but not lead to significant price declines and higher interest rates because I think that it is most likely that central banks will buy more of them to hold interest rates down and keep prices up. In other words, I suspect that the new paradigm will be characterized by large debt monetizations that will be most similar to those that occurred in the 1940s war years.
So, the big question worth pondering at this time is which investments will perform well in a reflationary environment accompanied by large liabilities coming due and with significant internal conflict between capitalists and socialists, as well as external conflicts. It is also a good time to ask what will be the next-best currency or storehold of wealth to have when most reserve currency central bankers want to devalue their currencies in a fiat currency system.
Most people now believe the best “risky investments” will continue to be equity and equity-like investments, such as leveraged private equity, leveraged real estate, and venture capital, and this is especially true when central banks are reflating. As a result, the world is leveraged long, holding assets that have low real and nominal expected returns that are also providing historically low returns relative to cash returns (because of the enormous amount of money that has been pumped into the hands of investors by central banks and because of other economic forces that are making companies flush with cash). I think these are unlikely to be good real returning investments and that those that will most likely do best will be those that do well when the value of money is being depreciated and domestic and international conflicts are significant, such as gold. Additionally, for reasons I will explain in the near future, most investors are underweighted in such assets, meaning that if they just wanted to have a better balanced portfolio to reduce risk, they would have more of this sort of asset. For this reason, I believe that it would be both risk-reducing and return-enhancing to consider adding gold to one’s portfolio. I will soon send out an explanation of why I believe that gold is an effective portfolio diversifier.
Martin Armstrong writes The yield curve has been inverted for the last month. An inverted yield curve occurs when long-term government debt yields fall below rates on short-term notes and bills. For stock market investors, an inverted yield curve is typically a sign that equities could peak before an economic recession will follow. It also can be a precursor to a bear market in stocks, where equities fall 20% or more from highs which is the typical forecast. Some have pointed to the escalating China trade war. Investors, the claim, are worried that the China trade war and U.S. tariffs will slow global economic growth.
The 10-year Treasury note yield fell to 2.24% in early trading on May 29. Yields on three-month Treasury bills rose to 2.35%, well above the 10-year rate. The 10-year Treasury note fell below 2% on June 25 following the release of weaker-than-expected consumer confidence data. The three-month note traded at 2.13.%. Ten-year rates stood at 2.69% at the start of 2019. On June 4, 10-year Treasury notes slipped to 2.1 in midday trading, its lowest level in 20 months.
But much the real trend driving the inverted yield curve is capital inflows seeking long-term yields. Much of the capital has moved in from Europe. In addition, the amount of money in fixed-income exchange-traded funds passed $1 trillion last month, an ascendance that has reshaped the market in which countries and companies raise money to pay their bills. This has also altered the yield-curve. These forces have changed the dynamics of the marketplace and the traditional inverted yield curve does not necessarily mean what it once did and more than central banks use to be in control of the economy or money supply.
“We’re moving from a world that was constantly globalizing to one breaking up into three different empires, each with their own currency, reference bond market, supply chains. There are massive investment implications.” –LOUIS GAVE from a recent feature article on him in Barron’s
The New Cold War
Given the back-and-forth between China and the US over the past year (trade wars, Huawei, threats to Hong Kong’s special status) President Xi Jinping has likely concluded that “just because you’re paranoid it doesn’t mean they aren’t after you”. Even if Xi and President Donald Trump exit their G20 meetings singing Kumbaya, China is likely to keep planning for a long, drawn-out cold war with the US. Given the bipartisan, anti-China rhetoric emanating from Washington DC, Beijing has to conclude that its key relationship has changed. The Nixonian policy of “bringing in China from the Cold” has now run its course. From Beijing’s perspective, the US’s new China policy seems to be containment—technologically, economically and geographically.
Thus, even while hoping for the best, any forward-thinking Chinese leader must now plan for the worst. This means dealing with China’s most glaring weaknesses of which there are three; namely, its dependence on overseas supplies of (i) technology/semiconductors, (ii) energy and (iii) US dollars.
Hong Kong is about to become an absolutely horrible place to be. The degree of Chinese… reconstruction of the island will be on par with the cultural genocide already being imposed upon the Uyghurs of China’s western Xinjiang region. It won’t last a week or a month or a year. We’re looking at something that will last at least a decade.
That will have deep implications for anyone doing business in the country.
At a minimum every ongoing reservation about operating in China is about to get a hard underline. Foreign business magnates like Tim Cook have so far been able to ignore the ethical implications of their firms’ China dependency. It is difficult to see that continuing in light of what’s about to occur.
And it isn’t simply about ethics. Many of the financiers that make Hong Kong work are Chinese citizens. Whether Bank of America or whoever is willing to stay in a place where their workers disappear is… questionable. But it doesn’t end there. It’s not just Chinese citizens; the extradition law also applies to foreigners. These companies are used to working in China, so it’s not that the Chinese system is so scary that they can’t stomach the country. It’s that none of these companies have tried to operate in China during an active crackdown.
Macro data surprises have remained negative compared to consensus estimates, in line with our longstanding scenario, but equity markets have disregarded this and seem to be driven by a blind trust in central bankers’ abilities to turn the trend around before a more severe earnings recession takes hold. Falling bond yields have also renewed the push for higher valuation multiples, hence profit neutral valuations are back at multi-year highs. Falling interest rates have challenged our value bias and triggered a further valuation divergence between the expensive and cheap ends of the equity market. We still believe there will be a marked earnings recession and view analysts‘ V-shaped earnings expectations into 2020 as very unlikely. There is a risk, however, that central bankers could manage to create a larger asset bubble before a more severe crash takes place in some distant future, but we see too many dark clouds on the horizon in the short term to dare play that scenario. Macro strategy: Bubble or trouble? Our models, particularly for the US, point to much lower growth than consensus expects, as well as rising wage costs, which should trigger a marked earnings recession. How have previous Fed easing cycles played out for equities in such a scenario? In four of five cycles, equities have performed well from one month before the first cut up to one month after. In all easing cycles, the S&P 500 has at some point been higher within twelve months than the day before the first cut. In the medium term, two easing cycles have appeared hand in hand with bull markets and three have accompanied bear markets. The difference seems to depend on the presence of a marked earnings recession or not. It has not been enough that the Fed has eased to get an all-clear for equities. We still expect global manufacturing to improve in 2020, but the number of detrimental trends in the fundamentals still bothers us in risk/reward terms, and represent a warning signal in our view.
Equities: Valuation and estimate risks remain We see a clear risk that we will enter an earnings recession and that analysts have not moderated expectations enough on top lines and profitability estimates. Long-term tailwinds for profit margins are gradually disappearing and in some areas turning to headwinds. With valuation levels on profit-neutral multiples once again approaching new highs, we doubt that the market will withstand the estimate cuts that we foresee. Given that we remain confident in our macro outlook and that believe earnings estimates will need to come down for 2019-20, we find support for our defensive positioning. Where we could go wrong could be an underestimation of market participants’ willingness to push the expected return even lower (in other words, buoying valuations even higher). We are very reluctant, however, to recommend playing such a scenario. Equity styles: Double down on value With interest rates falling and central banks turning more dovish, some wonder if we should abandon our value bias and accept that valuations do not matter in a low interest rate environment. We do not accept this view and advise doubling down on the value factor. First, the valuation discrepancy between the cheap and the expensive end of the market is unprecedented. Second, slower global growth in a low cost-of-capital environment should theoretically reduce valuation differences, not increase them. Third, we can demonstrate that expensive stocks tend to struggle as uncertainty rises (eg the VIX index). Finally, the cheap end of the equity market has become so much smaller given its abysmal relative performance of late that a much smaller capital allocation to the style is enough to turn the tide. For those not daring to take the full value plunge, we advise combining value with solid quality and cash-conversion traits
June 25 – New York Times (Jeanna Smialek): “Jerome H. Powell, chairman of the Federal Reserve, said… that the central bank is weighing whether an interest-rate cut will be needed as trade risks stir economic uncertainty and inflation lags. But he made clear that the institution considers itself independent from the White House and President Trump, who continues to push publicly for a rate cut. Mr. Powell said the case for a rate cut has strengthened somewhat given that economic ‘crosscurrents have re-emerged, with apparent progress on trade turning to greater uncertainty and with incoming data raising renewed concerns about the strength of the global economy.’ But he stopped short of saying a cut was guaranteed, noting that the Fed would continue to watch economic events unfold and would avoid reacting to short-term issues.”
June 24 – Bloomberg (Christopher Condon and Rich Miller): “Federal Reserve Bank of Dallas President Robert Kaplan… sounded a note of caution about cutting interest rates. ‘I am concerned that adding monetary stimulus, at this juncture, would contribute to a build-up of excesses and imbalances in the economy which may ultimately prove to be difficult and painful to manage,’ Kaplan wrote in an essay released by the Dallas Fed.”
June 28 – Bloomberg (Craig Torres and Michael McKee): “It’s too early to know whether policy makers should cut interest rates and whether such a reduction should be a quarter or half percentage point, Federal Reserve Bank of San Francisco President Mary Daly said…”
It would be one rather atypical backdrop for commencing monetary stimulus. Fox Business: “Dow Celebrates Best June in 81 years, S&P Best in 64 Years.” USAToday: “Stocks Post Best 1st Half Since 1997.” Newsmax: “Wall Street Soars 18%, Global Stocks Surge $18T in 1st Half.”
Bloomberg headline (Gowri Gurumurthy): “Junk Sales Hit 21-Month High as Issuers Lock in Lower Rates.” Junk issuance jumped to $28 billion in June, following May’s $26 billion. Year-to-date issuance of $130 billion is running 18% above comparable 2018.
June 28 – Bloomberg (Drew Singer and Vildana Hajric): “For anyone who was anxious that U.S. investors would be bowled over in 2019 by the biggest crush of new listings in more than a decade, some news. You were wrong. So far. Not only has one deal after another surged after pricing, but the market itself has shown no ill effects with billions of dollars of new equity sloshing around. In June alone, as the S&P 500 surged to records, 10 initial public offerings rose by 50% or more in their debut sessions, the most of any month since at least 2008. The average return of 37% is double gains earlier in the year. ‘We’re partying like it’s 1999,’ said Kim Forrest, chief investment officer at Bokeh Capital Management… ‘We’re bringing new companies to the public that we either use or we want to own.’”
According to Axios (using Baker McKenzie data): A total of 62 initial public offerings raised $25 billion during the second quarter, the strongest pace in five years. “Average IPO returns were 30% as Beyond Meat and the tech sector took flight.”
June 25 – Bloomberg (Vildana Hajric and Carolina Wilson): “As the risk of an economic slowdown lingers, exchange-traded fund investors are seeking shelter in bond funds. They’ve poured about $72 billion into fixed-income ETFs this year through June 24, with the funds on track for their biggest first-half inflows ever… Those bets have also fueled assets in the debt strategies to hit an all-time high of nearly $741 billion.”
It requires some creativity on the Fed’s part to justify additional monetary stimulus based on domestic conditions (I know, “inflation below target.”). Yet this is much more about global fragility than the U.S. economy. A positive outcome in Osaka would be constructive for sentiment from China to the U.S. Why then do global sovereign yields seem to look past the G20 (while equities can’t seem to shake the giddies)? Why would 10-year Treasury yields end the week down another five bps to (a near 30-month low) 2.00% – in the face of some Fed pushback on imminent rate cuts? How about German bund yields down four bps to a record low negative 0.33%. Swiss yields down to negative 0.58%, and Japanese 10-year yields at negative 0.16%? French 10-year yields turn negative (0.005%) for the first time, with Spanish yields down to only 0.40%.
Why do bond markets at home and abroad have about zero fear of a Trump/Xi agreement with positive ramifications for risk market sentiment and economic prospects (with, seemingly, receding central bank dovishness)? Because, I would posit, the collapse of bond yields is chiefly about unfolding global financial fragilities rather than trade disputes and slower growth. More specifically, faltering Chinese Bubbles significantly raise the likelihood of the type of global de-risking/deleveraging dynamic that would wreak havoc on securities and derivatives markets across the globe.
There are key elements of the current environment reminiscent of 2007. Recall that after the initial subprime scare that pushed the S&P500 down to 1,370 in mid-August, the index then rallied back to post a record high 1,576 on October 11th. After a weak November, the S&P500 ended 2007 at 1,475 (returning 5.6% for 2007). Meanwhile, the bond market was having none of it. After trading to 5.30% in mid-June, yields sank 127 bps by year-end (on the way to March’s 3.31% low) despite the widely held view the inconsequential subprime issue was to be quickly relegated to the dustbin of history.
These are two distinct Bubbles – the U.S. “mortgage finance Bubble” and the “global government finance Bubble.” Bond yields collapsed in 2007 in response to an unsustainable financial structure. There were Trillions of mispriced mortgage securities and derivative contracts that, because of egregious late-cycle excesses, were acutely vulnerable to any tightening of finance. Moreover, large quantities of mispriced securities were held on leverage.
“Crazy” end-of-cycle lending, risk intermediation, and speculative excesses became increasingly untenable. The more sophisticated market operators started to reduce exposure to the most suspect instruments. Subprime securities began to lose market value, and the marketplace turned increasingly illiquid. Credit conditions for the marginal (subprime) home buyer tightened significantly, which set in motion deflating home prices, pressure on higher-tier mortgage securities (i.e. “alt A”) and a more systemic tightening of mortgage Credit. What started at the “Periphery” gravitated to the “Core,” with Trillions of mispriced securities, speculative leverage, and ill-conceived derivatives coming under heightened pressure.
Even in the face of the subprime dislocation, the view held that “Washington will never allow a housing bust.” Indeed, the implicit government guarantee of GSE securities was more crucial than ever heading right into the crisis. Agency Securities actually increased a record $905 billion in 2007 (to $7.398 TN), perceived money-like Credit instrumental in sustaining “Terminal Phase” excess.
U.S. Non-Financial Debt expanded $2.478 TN in 2007, accelerating from 2006’s $2.432 TN and 2005’s $2.246 TN. The Credit Bubble was sustained by the combination of market confidence in the implicit federal guarantee of Agency Securities along with prospects for aggressive Federal Reserve stimulus (the Fed cut 50bps in September ’07 and another 25 bps in October and December), along with sinking market yields and lower prime mortgage borrowing costs.
This is where it gets interesting. Rapid Credit growth throughout 2007 underpinned stock prices, general consumer confidence and overall economic activity. Nominal GDP expanded at a 5% rate during 2007’s first half, 4.3% in Q3 and 4.1% during Q4.
Meanwhile, bond yields completely detached from equities and traditional fundamental factors. Why were yields collapsing in the face of booming Credit growth and inflating risk markets? Because the preservation of “Terminal Phase” excess was fomenting a late-cycle parabolic rise in systemic risk: inflating quantities of increasingly risky Credit instruments, dysfunctional risk intermediation, destabilizing market speculation, and extreme late-cycle imbalances/maladjustment. Stated somewhat differently: efforts to sustain the boom were exacerbating structural impairment. The bond market discerned an increasingly untenable situation.
History Rhymes. China’s Aggregate Financing (approx. non-government system Credit growth) jumped $1.60 TN during 2019’s first five months, 31% ahead of comparable 2018 Credit growth. So far this year, Aggregate Financing is expanding at better than 12% annualized. This is a rate of growth sufficient to sustain the economic Bubble (Beijing’s 6.5% growth target), apartment prices, corporate profits, stock prices and general market and economic confidence.
But extending the “Terminal Phase” has ensured a historic parabolic surge in systemic risk. Consumer (chiefly mortgage) borrowings have increased 17.2% over the past year (40% in two years!). Thousands of uneconomic businesses continue to pile on debt. Unprecedented over- and mal-investment runs unabated. Millions more apartments are constructed. The bloated Chinese banking system continues to inflate with loans of rapidly deteriorating quality.
Global risk markets have been conditioned for faith both in Beijing’s endless capacity to sustain the boom and global central bankers’ determination to maintain system liquidity and economic expansion. So long as Chinese Credit keeps flowing at double-digit rates, inflating perceived wealth ensures Chinese spending and finance continue to buoy vulnerable emerging market booms and the global economy more generally. Global risk markets remain more than content.
At this stage, however, global bonds have adopted an altogether different focus: China’s financial and economic structures are untenable. Sustaining rapid Credit growth is increasingly fraught with peril. With market players now questioning Beijing’s implicit guarantee for smaller and mid-sized banks and financial institutions, financial conditions are in the process of tightening at the financial system’s “Periphery.” And tightened Credit conditions have begun to reverberate in the real economy.
And what about the possible impact of a positive G20 and momentum toward a U.S./China trade deal? Stocks, no surprise, are readily excitable. For global safe haven bonds, however, it’s of little consequence. How can this be? Because even a trade deal would at this point have minimal impact on what has become deep and rapidly worsening structural impairment. Trade deal or not, Chinese exports to the U.S. will decline, right along with capital investment. Even with a deal, the Chinese financial system faces the consequences of years of rapid expansion, as economic prospects deteriorate. Sure, 6% growth as far as the eye can see. This implies a further surge in consumer debt and even more dangerous mortgage finance and apartment Bubbles. Unparalleled overcapacity and maladjustment.
Record U.S. stock prices in October 2007 made it easy to dismiss the momentous ramifications associated with subprime borrowers (the “Periphery”) losing access to cheap Credit – to disregard the blow-up of two Bear Stearns structured Credit funds, widening Credit spreads, pockets of market illiquidity, and waning confidence in some sophisticated derivative structures. Acute monetary instability (i.e. equities and $140 crude) was mistaken for resilient bull markets.
I would closely monitor unfolding developments in Chinese Credit – funding issues for small and mid-sized banks; ructions in the money markets; trust issues with repo collateral, inter-banking lending, and counterparties; vulnerabilities in local government financing vehicles (LGFV); heightened concerns for speculative leverage; and the overarching issue of the implicit Beijing guarantee for essentially the entire Chinese financial system. The overarching issue is one of prospective losses of monumental dimensions. These losses will have to be shared in the marketplace. As much as global markets bank on Beijing bankrolling China’s entire financial apparatus, the Chinese government will not welcome the prospect of bankrupting itself.
The solution, of course, is for China to simply inflate its way out of debt trouble – just like everyone else. What an incredibly dangerous myth the world fully bought into. Reflation – in the U.S., China, Europe, Japan and globally – has only inflated the size and scope of Bubbles. China could see $4 TN of new Credit this year – debt of increasingly suspect quality. Such reckless Credit excess is placing the Chinese currency at great risk. It took about 18 months from the initial U.S. subprime blowup to full-fledged financial crisis. While one could certainly argue for earlier (i.e. December), China’s crisis clock began ticking no later than with last month’s takeover of Baoshang Bank.
June 27 – Bloomberg: “Almost five weeks after Chinese officials shocked investors by taking over a regional bank, smaller lenders are still struggling with the consequences. Demand for their debt is tumbling. Debt issuance by small banks this month has tanked to a 16-month low. The cost of borrowing is surging. Lenders paid record high premiums on negotiable certificates of deposits — a type of short-term debt that they rely heavily on for funding — relative to bigger peers. While the central bank has injected a net 325 billion yuan ($47bn) into the nation’s financial system last week and lifted the short-term debt quota for big brokerages to ease the crunch affecting smaller banks, the measures have failed to shift investor concerns. The fact that some of Baoshang Bank Co.’s creditors may face losses has driven financial institutions to reassess counterparty risks and become more selective in whom to lend to… ‘Some institutions are mulling making white and black lists for small banks and that will affect credit expansion of those banks,’ said Lv Pin, an analyst with Citic Securities.”
June 24 – Bloomberg: “Liquidity conditions for China’s lenders and its non-banking financial institutions are heading in different directions following the surprise seizure of a bank last month. A measure of cash in the interbank system fell to its lowest close since 2009 on Monday, as the central bank has been providing liquidity to the market to ease concern over credit risks at small and medium-sized banks. That’s just as financial firms like insurers continue to face financing difficulties almost a month after the government takeover of Baoshang Bank Co. The People’s Bank of China injected a net 285 billion yuan ($41.5bn) of funds via open market operations last week, the most since late May. The problem is injections like these have not benefited non-banking firms that rely on corporate debt for funding because bond traders are still worried about counterparty risks. ‘Non-bank financial institutions have been having more difficulty in acquiring capital via negotiable certificates of deposit,’ said Ken Cheung, a senior Asian currency strategist at Mizuho Bank Ltd. ‘Large banks are less heavily affected.’ China’s overnight and seven-day pledged repurchase rates for the overall market rose to as high as 8% and 18.3% on Monday…Those prices indicate what non-bank financial institutions could be paying to get funding. The same rates for lenders were at 0.99% and 2.27%.”
June 26 – Bloomberg: “Investors in China’s local government financing vehicle bonds — the market’s hottest trade earlier this year — have a new risk to consider. At least that’s what yields are signaling, a month after the big jolt from the government’s Baoshang Bank Co. seizure. LGFV notes pay less than company debt because of the assumption that they carry an implied government guarantee, so they should have done relatively better in a risk-averse environment. Instead, borrowing costs for lower-rated LGFVs are rising while yields on corporate bonds are trending lower. It’s another example of the linkages between players in China’s financial system, not all of which are evident on the surface. As small banks struggle to access liquidity amid the Baoshang Bank fallout, that becomes a potential problem for their big borrowers — often weaker LGFVs. ‘As the risk appetite in the market has become quite low, lower rated LGFVs will have difficulties in refinancing and they will come under bigger pressure to repay debt,’ said Liu Yu, a fixed-income analyst with Guosheng Securities Co. ‘The risk of lower rated LGFVs is increasing and some may default on their borrowing through non-standard financing channels.’”
June 25 – Financial Times (Don Weinland and Sherry Fei Ju): “A rare public default at a Chinese trust company is drawing attention to cracks in the Rmb7.9tn ($1.13tn) market for the investment products in the country, where similar failures have been dealt with behind the scenes in the past. Anxin Trust, which missed payments on Rmb11.8bn for 25 trust products earlier this year, has been forced to publicly document its default because, unlike most trusts, it is listed on the Shanghai stock exchange. The situation has offered a rare glimpse into the factors leading up to failed trust products, which for Anxin include giving loans to an acquisitive property group that has since been delisted from a Chinese bourse. The trust company’s shares tumbled more than 9% on Tuesday after it said its parent company’s shares had been frozen by a court in Shanghai.”
June 24 – Bloomberg: “One of the most opaque areas of China’s credit markets involves the practice of companies buying their own bonds. That may soon get a lot tougher, contributing to financing difficulties that are already bedeviling the nation’s policy makers. At issue is a sharp increase in scrutiny by financial institutions of the collateral that their counterparties offer up in the repurchase market, a crucial channel for short-term funding. If the debt sold by issuers that indirectly purchased a portion of their own bonds — which could account for as much as 8% of China’s corporate bonds, according to Citic Securities Co. — is shunned, that will squeeze liquidity for a swathe of the nation’s businesses.”
June 26 – Financial Times (Don Weinland): “Chinese regulators are hitting the brakes on a record surge in US dollar bond sales by local government financing companies despite unprecedented demand for the debt. Local government financing vehicles, which have been used for years by Chinese cities and provinces to raise funds for local infrastructure projects, sold $12.4bn in US dollar bonds in the first half of the year, according to Dealogic, nearly doubling issuance from the same period last year. The boom in debt deals, however, is expected to come to an abrupt end on Friday, after which Chinese regulators are likely to impose stricter rules on the companies.”
Globally,
the stock of negative-yielding debt crossed a record $13 trillion on Thursday,
according to data from Bloomberg. That represents 26% of global sovereign debt
supply and 15.3% of nominal worldwide GDP for 2018. Stateside, the 10-year
Treasury yield remains below 2%, down from 3.25% in November.
In a New
York Times opinion piece last Sunday, Ruchir Sharma, chief global
strategist at Morgan Stanley, discussed the fallout from the incredible
shrinking interest rates. Citing a report from the Bank for International
Settlements, which found that 12% of publicly listed companies around the world
can be described as zombie firms (meaning they don’t earn sufficient profits
with which to cover their interest payments), Sharma concluded that simple
policy miscalculations are on display:
Once the
crisis hit, governments erected barriers to protect domestic companies. Central
banks aggressively printed money to restore high growth. Instead, growth came
back in a sluggish new form, as easy money propped up inefficient companies and
gave big companies favorable access to cheap credit, encouraging them to grow
even bigger.
Other
academic studies lend credence to Sharma’s, and the BIS’s claims. On January
22, the National Bureau of Economic Research released a paper examining the
effects of low interest rates on economic dynamism. Incumbents will like what
they see:
A
reduction in long-term interest rates tends to make market structure less
competitive within an industry. The reason is that while both the leader and
follower within an industry increase their investment in response to a
reduction in interest rates, the increase in investment is always stronger for
the leader. As a result, the gap between the leader and follower increases as
interest rates decline, making an industry less competitive and more
concentrated.
When
interest rates are already low, this negative effect of lower industry
competition tends to lower growth and overwhelms the traditional positive
effect of lower rates on growth.
In
January 2017, the Organisation for Economic Co-operation and Development
released Working Paper No. 1372, which reached a similar conclusion:
Evidence
of a decline in productivity-enhancing reallocation is particularly significant
in light of rising productivity dispersion, which would ordinarily imply
stronger incentives for productive firms to aggressively expand and drive out
less productive firms.
Instead,
the productivity gap between frontier and laggard firms has risen, even while
the forces bringing dynamic adjustment are waning. This tension is a red flag
that something is wrong with productivity, but also points to a potential
deterioration of the exit margin [meaning fewer firms are going to corporate
heaven].
E-Z money
likewise helps bring the dead back to life. As noted by Marty Fridson, chief
investment officer of Lehmann, Livian, Fridson Advisors, LLC, during the Spring
2014 Grant’s Conference, the 2008-2009 default cycle was anomalously
brief: “We actually had the situation where the default rate went from a record
level to below average the very next year. I would submit that is physically
impossible, but it did actually happen.”
Needless to say, the march lower in interest rates will help this encumbered group continue to walk the earth. As compiled by Ben Breitholtz, data scientist at Arbor Research & Trading, LLC and noted in the March 8 edition of Grant’s, the proportion of zombie companies (defined here as those whose operating income fails to cover interest expense for three straight years) in the S&P 1500 Index rose to 13.6% at the end of January. That’s up from 12.4% year-over-year and compared to less than 6% of that broad cohort in 1990. During that period, the yield on 10-year Treasury Inflation Protected Securities declined to less than 1% from more than 14%. Breitholtz also spotted a key threshold for this undead cohort, telling Grant’s in March: “We noticed that the closer the 10-year real yield gets to 1%, there is a hypersensitivity for a lot of these overleveraged companies.” With the 10-year real yield now sitting below 20 basis points, the corporate undead continue to roam.
The only time gold has rallied significantly is when the CONFIDENCE in government declines. That was the case during the post-1976 era for people saw inflation as running away. That was because of OPEC creating STAGFLATION meaning it was cost-push inflation that eventually converted to demand-push inflation by mid-1979. I understand that all of these gold-bug analysts have been preaching hyperinflation for decades. The whole Quantitative Easing (QE) was supposed to create $10,000 gold years ago. Here, after 10 years of QE, gold remains trapped in a consolidation.
Gold will be the hedge against political uncertainty and government ONLY when the people reach that critical point of losing faith in government. We are at the 35% level where people believe the government is the number one problem. When that crosses the 45% mark, things will start to become different. This has nothing to do with the quantity of money. Most millennials use their phones to buy things or credit cards – not cash. The idea of gold as a store of value has faded between generations. The worst thing you could do is judge the world by what you believe. Everyone will act only on their own reasoning and belief system.
Let’s dig into a few things that are piquing our interest this week. We feel that investors need to be fully aware and cognizant of the investment landscape that is currently controlled by the global central banks. The recent bout of economic volatility should be here to stay as the Federal Reserve shifts its tightening campaign and reverses its course rather quickly over the coming months. Speaking of the Federal Reserve they are meeting this week in Chicago to review current monetary policy. As this Bloomberg article points out, the Fed and group of academics get together to discuss new research and complex topics. Well one thing will be certain, whatever they come up with will be well behind the curve and as the past has consistently proven, the FED and their 700 PhD’s are chalk full of terrible prognostication capabilities.
In fact we have this chart here just to show you how severe the 360 degree change has been over the last few months as all the quants that were predicting Fed continued tightening which was expecting nearly 80 basis points of tightening at the end of last year, to now calling for 50 basis points of easing. With this newly found trajectory this chart points out the over exuberance of the SP500 market in comparison to the new expected path of lower rates. Who said markets are efficient, BS we know better? Basically, the question becomes, do you believe the bond markets or the equity markets right now??? We know where we stand!
