9/3/20: Beware the Endlessly Inflating Global Debt Bubble

My latest article for Manning Financial on the global debt overload is available here: https://issuu.com/publicationire/docs/mf_spring_2020?fr=sZjI3NzI2MTg4NA. Alternatively, see posted below (click on each image to magnify):

14/91/17: Risk, Uncertainty, Political Risks and Markets

My article on the links between political risks, financial returns and economic growth in the MFTimes: http://issuu.com/publicationire/docs/mf_august_2017?e=16572344/51951043 pages 5-7.

30/6/17: Manning Financial: The End of the Trump Boom?

My recent contribution to Manning Financial for Summer 2017 is available here: http://issuu.com/publicationire/docs/mf__summer_2017?e=16572344/49275504

24/2/17: Monetary Policy Outlook for 2017

My article for Manning Financial covering monetary policy outlook is out and can be viewed here: https://issuu.com/publicationire/docs/mf_february_2017__1_?e=16572344/44717793.

Alternatively, click on the following images to enlarge

31/5/16: Markets Outlook: Summer 2016

My latest contribution for Manning Financial covering markets outlook: https://issuu.com/publicationire/docs/mf_summer_2016?e=16572344/36072504

18/2/16: Is the U.S. About to Slip into a Recession?

This is an unedited version of my article for Manning Financial. Final version is available here: https://issuu.com/publicationire/docs/mf_magazine_spring_2016_17022016_ne?e=16572344/33514016

In almost every sharp downshift in economic activity, and more frequently than that, in almost every economic recession, there are several regular predictors or leading indicators of tougher times ahead. These include sharp drops in corporate profits, and acceleration in yields on lower rated corporate bonds, usually followed by significant declines in industrial production indices and subsequent downward corrections in stock markets and services activities indices.

While these sequences of events repeat with regularity, in many cases, forward signals of recessions can involve a slight variation in timing and permutations of these shocks.

Another regularity that happens when it comes to business cycles is that, traditionally, the U.S. leads Europe into the downturn.

Trouble is, judging by all factors mentioned above, the U.S. is currently heading into a recession. Fast. And with some vengeance.

The Bad News

Let’s start with corporate profits. The latest data from the U.S. Federal Reserve shows that year-on-year 3Q 2015 growth in corporate profits for non-financial corporations was sharply negative - at -4.26 percent. Furthermore, corporate profits growth slowed down from 7.72 percent in 1Q 2015 to 1.83 percent in 2Q 2015. The rate of decline in corporate profits growth in the U.S. is now sharper than during the last GDP wobble in 1Q 2014 and sharper than in 3Q 2008. The latest growth figure also marks the fastest rate of decline in profits since 3Q 2009.

CHART 1: Non-Financial Corporate Profits and Nominal GDP

Growth Rates, Percent per annum

Source: Author own calculations based on data from the Federal Reserve Bank

Chart above shows clear pattern of correlation between corporate profits growth rates and subsequent growth rate in nominal GDP. It also shows that U.S. corporate profits growth rates have been on a declining trend since 3Q 2010.

Meanwhile, corporate debt yields are shooting straight up. Added to this dynamic is another troublesome sign: yields volatility is also on the rise. In other words, the markets are not only nervous about individual issuers, but are appearing to be scared of the entire asset class. I wrote about this phenomena in previous newsletter, here. Behaviourally, international and U.S. investors have been running for the hills for some time now, despite the extremely risk-supportive monetary policies not just by the Fed, but also by major carry trade-sustaining central banks (Bank of Japan and ECB). In normal conditions, carry trade drivers should moderate risk aversion effects. Except they are not doing so today.

As noted in a recent research note by J.P. Morgan Cazenove in general, credit spreads lead equities and the former “are not giving a positive signal” to the latter (see: http://trueeconomics.blogspot.com/2016/01/24116-high-yield-bonds-flash-red-for.html).

So that puts two recession-beaconing stars into a perfect alignment.

What about the U.S. Industrial Production? From over 2015, U.S. industrial output posted declines, based on monthly growth rates, in ten months out of twelve, with December 2015 production levels down almost 2 percent on December 2014 peak. In annual growth terms, output growth rate started at a brisk 4.48 percent pace in January 2015 and ended the year with a contraction of 1.75 percent - the sharpest rate of decline since December 2009. That’s a swing of some 6.23 percentage points in 12 months.

CHART 2: U.S. Industrial Production Index

Monthly growth rates, percent

Source: Author own calculations based on data from the Federal Reserve Bank

Like with corporate bonds and profits, some of this is down to a combination of commodities recession and Emerging Markets woes.

The former is pretty apparent to all concerned. Between the start of 2014 and the end of 2015, the weighted average price of oil across three key grades (Brent, WTI and Fateh) fell 51.1 percent. Non-fuel commodities went down 21 percent.

The latter also was subject to my earlier contributions to this newsletter. To update you with the latest news, while Emerging Markets continued to contribute some 70 percent of overall global growth in 2015, the rate of growth in key BRICS economies (including Brazil, Russia, India, China and South Africa) has been tanking.Per latest IMF forecasts, released earlier this month, Emerging Markets are still expected to grow by 4.3 and 4.7 percent in 2016 and 2017. However, this puts their growth rates below the 2011-2014 average of 5.3 percent and the 2000-2007 average of 6.5 percent. Amongst the BRICS, all but China and India are either already in a recession or one quarter away from a recession. China is expected to post official growth of 6.9 percent in 2015, with forecast for 2016-2017 for 6.3 percent and 6.0 percent, respectively. Even if trust Chinese official statistics, this represents a big drop. For example, 2015 has been the slowest year in terms of GDP growth in 25 years, and the fourth slowest in 36 years.

But beyond these two factors, U.S. output growth is also being pushed down by stronger Dollar and collapsing global trade. Global trade has been tracking the declining fortunes of global demand since 2012. Over the last four years, global trade volumes growth underperformed post-crisis average and historical average, pushing growth rates to their lowest readings for any decade on record. In line with this, Baltic Dry Index – the cost indicator for hiring cargo vessels to ship goods around the world – has been hitting historical lows almost on a daily basis since the second part of December 2015.

All of the above factors, from falling profits, to falling production growth rates, to underlying commodities recession, global demand weaknesses and international currencies re-valuations, have undoubtedly contributed to falling equity prices. Since the start of 2016, some forty major equity markets around the world have entered bear territory. While on the corporate side of the U.S. economy, oil and commodities prices recession has been a dominant driver for aggregate equities indices movements, underlying equity price swings are much broader currents. For example, equities sell-offs around the world did not concentrate on commodities producing sectors and companies, or on highly leveraged corporates alone. Instead, the bear markets have been broad.

The Good News

Which brings us to last piece of a puzzle, yet to fall into its place: consumer demand. Or put into the above context – the good news bit.

Falling equity and bond prices, as well as rising retail interest rates are capable of triggering - if sustained over time - drops in consumer confidence, followed by households’ pulling back from consumption and investment. So far, stronger dollar (improving U.S. consumers’ purchasing power), lower energy prices (improving their disposable incomes) and falling unemployment (improving household pre-tax incomes) have sustained consumer confidence at healthy levels.

CHART 3: Index of the U.S. Consumer Sentiment

Source: University of Michigan

However, current levels of consumer confidence are barely touching pre-crisis averages and have declined since local peak in January 2015 through 3Q 2015. There is no crisis at the moment, but given the strength of household finances, 2015 index performance was hardly spectacular.

Whatever resilience we do see in consumer surveys, it is most likely underpinned by the positive jobs prints. Based on historical figures, over each recessionary episode in the U.S. history since the end of the World War II, employment was one of the key casualties, declining with every recession by at least 1 percentage point. U.S. added 2.597 million new private sector jobs over the course of 2015 and average weekly earnings are rising in both goods-producing and services-providing sectors.

The Latest Official Forecasts

This is precisely why despite the leading indicators flashing bright warning signs of the potential incoming recession, the IMF continues to forecast rather robust – by comparatives to the Euro area, UK and Japan – for the U.S. in 2016 and 2017. Per January update to its forecasts, the IMF now expects U.S. economy to grow at 2.6 percent in both 2016 and 2017. This comes against the Fund forecast for 2.2 percent growth in 2016 and 2017 in the UK, 1.7 percent real growth in the Euro area over the same period, and 1 percent and 0.3 percent growth in Japan in 2016 and 2017, respectively. However, IMF’s latest forecast represents a sizable downgrade for the U.S. compared to previous forecasts. Thus, compared to October 2015 outlook, IMF expectations for U.S. economic expansion are now 0.2 percentages lower for both 2016 and 2017.

Still, IMF references the U.S. as one of the four core risks to its global outlook for 2016. Specifically, the IMF cites the risk arising from “tighter global financing conditions as the United States exits from extraordinarily accommodative monetary policy”.

This risk, along side growing uncertainty about overall health of the U.S. economy, are material factors for Irish and European markets and investors. Ireland benefited significantly from the U.S. recovery and subsequent devaluation of the Euro vis-à-vis the U.S. dollar. These factors underpinned our exports of goods to the U.S. and Canada rising by EUR6.85 billion for the first eleven months of 2015 compared to the same period in 2012. This growth is more than double the rate of expansion in our trade in goods with the EU (including the UK). From Irish investors perspective, our domestic assets performance – across both equities and bonds – owes a lot to the resilience of the U.S. economy. Likewise, our investors’ access to diversified portfolios of internationally-listed and traded assets cannot be imagined absent the U.S. equity and debt markets.

All of this is currently at risk when it comes to the U.S. economic and markets performance forward. And more ominously, our own European economic and investment fortunes are tied closely to the North American economies. Whenever you hear any political leader – be it Enda Kenny or Jean-Claude Juncker – extoling the virtues of Ireland’s or Europe’s firewalls against international shocks, remember the old adage: when America sneezes, Europe catches the cold.

  

16/4/15: QE and Negative Rates: It's So Good, It Hurts...

Here is an unedited version of my article for Manning Financial on the upcoming pain in the global markets from the Central Banks activism.


With spring sunshine, the glowing warmth of the overheating bonds markets is bringing about the scent of optimism to the macro-analysts' desks. On March 19th, the NTMA issued EUR500 million worth of 6mo notes with a yield of -0.01%. With a few strokes of the 'buy' keys, the markets welcomed Ireland to the ever-expanding club of nations that enjoy the privilege of being paid to borrow from private investors.

In a way, this is the story of Ireland's recovery distilled to a singular event: with the Government borrowing costs at their historical lows, the memory of the recent crises is fading fast from the pages of our newspapers. Alas, the drivers of this recovery are illusory. All are temporary, none are structural or sustainable, in the long run. In fact, the current markets reprieve is concealing the real dangers for domestic investors – dangers of new asset bubbles and potential future losses.

Take a look at the euro area sovereigns at large.

After years of austerity, 2015 is shaping up to be a year of broadly-speaking neutral public spending. In other words, as the euro area Governments' debt remains sky high, public deficits are unlikely to shrink by any appreciable amount. Why bother with reforms, when you can be paid by the markets to borrow? Aptly, as the chart below shows, European economic policy uncertainty remains at crisis period averages, well above the safety range of pre-crisis years.


European Policy Uncertainty Index  (including period averages confidence intervals)

Source: data from PolicyUncertainty.com


Although the Government is usually quick to claim credit for the massive improvements in Irish yields, in reality, Dublin has little to do with these. At every point from Q3 2011 through today, large scale declines in the Government cost of borrowing came courtesy of the ECB. The latest gains are no exception: the ECB has just launched a sizeable bonds-buying programme and with it, the quantum of negative yield debt in the global markets has gone from roughly USD3.6 trillion in January to USD4.2 trillion by mid-March. As of now, 19 percent of the Global Bond Index-listed debt is trading in negative rates territory.

This, by far, represents the largest long term challenge for investors and the greatest risk to the global economies. Expansionary monetary policy pursued by the central banks around the world, including the ECB aims to push up economic growth and reduce the risks of deflation. It also attempts to repair the monetary policy transmission mechanism: that cheap ECB-supplied liquidity is being lent by the banks to companies and households in the forms of new credit.


TANGIBLE RISKS

However, from the investors’ perspective, this monetary activism can end up backfiring. For a number of reasons.

Firstly, as shown in Chart 2 below, monetary policy-driven credit expansion is propelling stock markets and debt markets valuations to all-time highs across the advanced economies with absolutely no tangible connection to real fundamentals, such as growth in economic activity, household incomes, employment, and even capital investment. By the very definition of the financial bubbles, current monetary policies activism is inflating returns expectations unanchored in reality.

Secondly, monetary expansion means that households and firms struggling with debt are given a short-run reprieve from facing the true costs of their borrowings. But the day of reckoning awaits in the future. This means that households and corporates are likely to continue engaging in precautionary savings even as the Central Banks drop rates and bonds markets bid the cost of issuing debt down. Meanwhile, households and companies with low debt exposures are likely to save more to offset declines in their returns on deposits. Taken together, these factors are likely to further suppress domestic demand, while setting us up for a major crisis once the cost of debt starts rising in the future.

Thirdly, negative yields are, like all bubble-generating factors, self-reinforcing in their nature. With central banks increasingly charging commercial banks for deposits, banks prefer buying bonds even in the presence of the negative yields. This means that negative policy rates are reinforcing the dysfunctional monetary mechanism, locking in more liquidity into government bonds and driving yields on government paper further down. The resulting increases in bonds prices incentivise commercial banks to gamble on future capital gains by buying even more bonds. This spiral of demand for government debt depresses banks future profitability as investors bid bonds prices up and loads more risk of significant future losses that will materialise once QE policies begin to unwind.

Another pesky side effect of this is the banking sector stability. Negative interest rates on Central Bank deposits lead to lower deposit rates for banks' customers. Banking sector loans-to-deposits ratios rise, making banks more dependent on the shadow banking system for funding and more levered. Interestingly, in the U.S. at least one large bank, J.P. Morgan has already announced that it will be charging customers for large deposits up to 5.5 percent annual fee.

Fourthly, negative rates and yields are increasing the probability of monetary policy misfires - a scenario where one or several Central Banks around the world can tighten policy too fast and/or too early, completely derailing economic recovery. This problem is global and contagious. Investment grade government bonds are effectively substitutes for each other in majority of investment portfolios. As the result, negative yields in the euro area today are keeping yields low in other advanced economies. This is already causing discomfort in the U.S. where dollar rise relative to other currencies is being driven by a combination of two factors: the expected mismatch between U.S. and euro area policy rates, and investors' fear of Fed policy errors over the next 3-6 months.

Fifthly, the demand for negative yield bonds appears to be setting the unsuspecting investors for a fall. In a recent research note, the investment bank Jefferies discovered that much of the demand for such paper comes from indexed funds. Investors in these extremely popular funds simply have no idea that the strategy the funds pursue is not designed for the world where top-rated bonds are paying negative yields. And as funds start posting losses, the same investors are likely to rush for safety into other asset classes – namely equity. Yet, with equities already at historical highs, the safety-minded investors will be left with buying even more assets at bubble valuations.

Sixthly, negative yields on Government bonds are a disaster waiting to happen for insurance, asset management and pension sector as they create huge risks at the heart of these companies long-term investment portfolios. As insurance companies and pensions funds chase the yield, premia will have to rise, risks embedded in pensions portfolios will jump and returns on longer term contracts will fall. As the result, some financial analysts are warning of not only economic, but also political consequences of the monetary policy activism.

The bankers' regulatory body, the Bank for International Settlements is not amused. In a recent statement, Claudio Borio, the head of the BIS monetary and economic department said it is simply impossible to tell how investors, consumers, voters and the governments are going to react to the negative yields and interest rates. "…technical, economic, legal and even political boundaries may well be tested. The consequences should be watched closely, as the repercussions are bound to be significant, on the financial system and beyond," Mr Borio said.


IRISH INVESTOR PERSPECTIVE

From Irish investors point of view, the risks arising from the euro area negative rates and yields environment are significant.

In a study published in 2005 (http://www.bis.org/publ/work186.pdf), BIS researchers found asset price busts, especially those associated with large property markets adjustments, to have much more painful economic impacts than deflation. The study covered all advanced economies over the period from 1873 through 2004 and included analysis of deflation effects on Government debt and growth. The same results were on firmed by another BIS study published earlier this year (http://www.bloomberg.com/news/articles/2015-03-18/the-central-bank-of-central-banks-says-keep-calm-about-deflation).


Global Markets, Irish Problems

Source: Author own calculations based on data from CSO, Central Bank of Ireland and Bloomberg

As of today (see Chart 2), Ireland is still experiencing property prices that are 38 percent below the pre-crisis peak (in Dublin 39 percent), private debt that is, once controlled for sales of mortgages, and Nama and bank loans to non-banking investors, stuck around mid-2005 levels, and growth predominantly driven by the multinational corporations' tax optimisation strategies. In this environment, negative rates are masking the extent of the problems still present in the economy, while euro devaluation, coupled with exports growth concentration in the MNCs-led sectors, are creating a false impression of improved productivity and competitiveness.

For domestic investors, this means that both equity, corporate and government debt markets  in Ireland and across the euro area are simply out of touch with macroeconomic reality on the ground. The global Central Banks-led policies are pushing our traditional investment and pensions portfolios into the high risks, low returns corner, commonly associated with financial assets bubbles. While some speculative exposure to the US and Emerging Markets assets is always welcome, the bulk of investment allocation today should be focused on conservative view of key risks presented by the negative rates and yields environment. Tax planning, portfolio cost minimisation, low gearing and high liquidity of investment allocations should take priority over pursuit of short term yields and capital gains.