Macroeconomics for Professionals

Starting-out note:  there’s an investment idea in here eventually.

I’ve been going through Macroeconomics for Professionals:  a Guide for Analysts and Those Who Need to Understand Them, written by two IMF professionals, with the intention of giving it, or something like it, to one of my children who’s getting more interested in stock market investing.  I’m not finished with the book, but so far, so good.

counter-cyclical government policy

The initial chapter of MfP is about counter-cyclical government policy, a topic I think is especially important right now.

Picture an upward sloping sine curve.  That’s a stylized version of the pattern of economic advance and contraction that market economies experience.  Left to their own devices, the size of economic booms and subsequent depressions tend to be very large.  The Great Depression of the 1930s that followed the Roaring Twenties–featuring a 25% drop in output in the US and a decade of unemployment that ranged between 14%-25%–is the prime example of this.  National governments around the world made that situation worse with tariff wars and attempts to weaken their currencies to gain a trade advantage.  A chief goal of post-WWII economics has been to avoid a recurrence of this tragedy.

The general idea is counter-cyclical government policy, meaning to slow economic growth when a country is expanding at a rate higher than its long-term potential (about 2% in the US) and to stimulate growth when expansion falls below potential.

 

applying theory in today’s Washington

Entering the ninth year of economic expansion–and with the economy already growing at potential–Washington, which had provided no fiscal stimulus in 2009 when it was desperately needed, decided to give the economy a boost with a large tax cut. Although pitched as a reform, with lower rates offset by the elimination of special interest tax breaks, none of the latter happened.  Then, just a few days ago, Washington gave the economy another fiscal boost.  Mr. Trump, channeling his inner Herbert Hoover, is also pressing for further interest rate cuts to achieve a trade advantage through a weakened dollar.

This is scary stuff for any American.  The country faced a similar situation during the Nixon administration, which exerted pressure on the Fed to keep rates too low during the early 1970s.  Serious economic problems that this brought on didn’t emerge until several years later, when they were compounded by the second oil shock in 1978 (that was my first year in the stock market; I was a fledgling oil analyst).

why??

Why, then, is Mr. Trump trying to juice the US economy when he should really be trying to wean it off the drug of ultra-low rates?

I think it’s safe to assume that he doesn’t understand the implications of what he’s doing (the thing Americans of all stripes recognize, and like the least, about Mr. Trump, a brilliant marketer, is how little he actually knows).   If so, I can think of two reasons:

–as with many presidents a generation ago, he may see ultra-loose money as helping his reelection bid, and/or

–the “easy to win” trade wars may be hurting the US economy much more deeply than he expected and he sees no way to reverse course.

If I had to guess, I suspect the latter is the case and that the former is an added bonus.  I think the main counter argument, i.e., that this is all about the 2020 election, is that the administration seems to be systematically eliminating any parties/agencies that want to investigate Russian interference in domestic politics.

Either would imply that software-based multinational tech companies that have led the stock market for a long time will continue to be Wall Street winners–and that the weakness they are currently experiencing is mostly an adjustment of the valuation gap (which has become too large) between them and the rest of the market.

In any event, interest rate-sensitives and fixed income are the main areas to avoid.  If the impact of tariffs is an important motivating factor, then domestic businesses that cater to families with average or below-average incomes will likely be hurt the worst.

 

 

 

 

Investing in an age of deglobalization

Rana Foroohar is one of my favorite Financial Times columnists.  The subtitle of her July 21st column about deglobalization is “The wisdom of relying on the equity of US multinationals is now suspect.”  Her conclusion is that in the years to come the real economic dynamism in the world is going to come from China and emerging markets.  The way for foreigners like us to participate is to own Chinese and other emerging markets equities themselves rather than use US multinationals as proxies.

I think Ms. Foroohar’s conclusion is correct, although I don’t think the reasons she gives are.  That’s a surprising departure from her usual incisiveness.  For what it’s worth, here’s my take:

–over the past thirty or forty years, economic expansions in the US and Europe were especially robust because they were fueled not only by reviving domestic demand but also by high-beta growth in international trade.  That period is now over.  The main reason, in my opinion, is that the large, relatively open, stable economies in the Pacific have already been fully penetrated by multinationals, so there’s no extra cyclical oomph to be had.  In addition, the developed world has also become more protectionist.  And the increasingly overt racism of the administration in the US is making American goods and services things to be avoided rather than aspirationally purchased.

–the 1980s-style argument of US investment managers with no knowledge of foreign markets and no inclination to learn is that US-based multinationals are an adequate substitute.  By and large, this has been incorrect, although there have been periods, like the 1990s, when Japan was collapsing and the US was king.

–Ms. Foroohar cites Warren Buffett, a holder of American Express, Proctor and Gamble, Kraft Heinz and Coca-Cola, as an advocate of the approach in the paragraph above–and as a case study of why buying US-based multinationals no longer works.  But as I see it, these are all names with sclerotic corporate managements who have been pretending that Millennials and the internet don’t exist.  Add IBM, a former big Buffett holding, to that pile.   Multinationals like Google, Microsoft, Amazon and Disney haven’t had the same issues.  Note, too, that both MSFT and DIS had to toss out backward-looking managements before achieving their recent success.

–I do think that China should be a key element of any long-term-oriented stock portfolio.  In addition to the secular growth story, the current Washington strategy of forcing US-based multinationals to move low-end manufacturing out of China will likely end up giving China a substantial economic boost.  Similarly, the use of the dollar as a political weapon–the arrest of the Huawei founder’s daughter on money laundering charges, for example–creates a big incentive for China to speed development of its domestic capital markets, making finance easier to obtain for fledging firms there.

However, as with any other foreign market, there is a price to be paid for entry.  The rules of the investing game–the investment preferences of locals, the reliability of accounting statements and regulatory filings–are likely different from those in the home market.  All this needs to be learned.  My approach with China far has been to stick with Hong Kong-listed names, where these risks are lower.  Nevertheless, it seems clear to me that there will be greater opportunities for knowledgeable investors on mainland exchanges.  Sooner or later we’ll all have to teach ourselves, or find an expert manager to rely on.

 

 

cutting the fed funds rate

The main value you and me in Mohamed El-Erian’s observations on financial markets is that he has a knack for framing accurately, if longwindedly, the consensus view of financial professionals on topics of the day.  Nothing profound, but a solid base for figuring out how to fashion contrary bets.

In a piece for Yahoo Finance this week, however, Mr. El-Erian has neatly made a number of points about the fed funds rate cut that seems to be on the cards for later this month:

–there’s little justification for the cut on traditional economic grounds

–the reduction will likely have little impact on the real economy

–the cut won’t weaken the dollar, because other nations will reduce their equivalent rates

–at a time when financial speculation is already running hot, a rate cut risks adding accelerant to the fire

–cuts reduce the scope for the Fed to act in case of a real financial emergency

–the Fed will lose at least some credibility as an independent body whose signals should be followed by financial markets (my note: in fact, the parallels are already being drawn between Trump and Nixon, whose meddling with the Fed for political reasons in the early 1970s led to financial disaster later in that decade).

no good reason to cut, so why?

If everything’s going so well, why bully the Fed into easing?

I think it has to do with stock market earnings growth.  Last year overall eps for the S&P 500 grew by about 18%.  My back-of-the-envelope estimation is that operating earnings grew by 8% and the other 10% was a one-time upward adjustment for lower US taxes.  A reasonable guess for 2019–without including the negative effect of tariffs–would have been another 8% growth for the US portion of S&P earnings and, say, 6% for the foreign component.  Figuring that both are roughly equal in size, that would imply +7% for 2019 eps.

So far, though, eps are coming in about flat. And analyst predictions, always on the sunny side, are now for slight year-on-year dips for the June and September quarters.  Yes, Europe is weaker than one might have thought.  So that’s a (small) part of the disappointment.  But it seems to me the Trump tariffs + retaliation to them must be biting much deeper into the domestic economy than Wall Street (or I) had been expecting.   …and that’s without considering the longer-term structural harm I think they are likely to do.

If so, the solution is to find a face-saving way to reduce or eliminate tariffs.  it is certainly not to introduce further distortions into fixed income markets.

PS:  it seems to me that the best way to compete with China is to strengthen the education system and to support government-assisted scientific research.   Both are non-starters in today’s domestic politics.

 

 

 

shrinking bond yields ii

why look at bonds? 

If we’re stock market investors, why are we interested in bonds anyway?  It’s because at bottom we’re not really interested in stocks per se.  We’re interested in liquid publicly-traded securities–i.e., stocks, bonds and cash.  We’re interested in publicly-traded securities because we can almost always sell them in an instant, and because there’s usually enough information available about them that we can make an educated decision.

 

comparing bonds with stocks

bond yields, at yesterday’s close

One-month Treasury bills = 2.18%

Ten-year Treasury notes = 2.07%

30-year Treasury bonds = 2.57%.

S&P 500

Current dividend yield on the index = 1.7%.

 

According to Yardeni Research (a reputable firm, but one I chose because it was the first name up in my Google search), index earnings for calendar year 2019 are estimated to be about $166, earning for the coming 12 months, about $176.

Based on this, the S&P at 3000 means a PE ratio of 18.0 for calendar year 2019, and 17.0 for the 12 months ending June 2020.

Inverting those figures, we obtain an “earnings yield,” a number we can use to compare with bond yields–the main difference being that we get bond interest payments in our pockets while our notional share of company managers remains with them.

The 2019 figure earnings yield for the S&P is 5.6%; for the forward 12 months, it’s 5.8%.

the result

During my time in the stock market, there has typically been a relatively stable relationship between the earnings yield and 10-/30-year Treasury yields.  (The notable exception was the period just before the 2008-09 recession, when, as I see it, reported financials massively misstated the profitability of banks around the world.  So although there was a big mismatch between bond and stock yields, faulty SEC filings made this invisible.)

At present, the earnings yield is more than double the government bond yield.  This is very unusual.  Perhaps more significant, the yield on the 10-year Treasury is barely above the dividend yield on stocks, a level that, in my experience, is breached only at market bottoms.

Despite the apparently large overvaluation of bonds vs. stocks, there continues to be a steady outflow from US stock mutual funds and into bond funds.

the valuation gap

Using earnings yield vs coupon rationale outlined above, stocks are way cheaper than bonds.  How can this be?

–for years, part of world central banks’ efforts to repair the damage done by the financial crisis has been to inject money into circulation by buying government bonds.  This has pushed up bond prices/pushed down yields.  Private investors have also been acting as arbitrageurs, selling the lowest-yielding bonds and buying the highest (in this case meaning Treasuries).  This process compresses yields and lowers them overall.

–large numbers of retiring Baby Boomers are reallocating portfolios away from           stocks

–I presume, but don’t know enough about the inner workings of the bond market to be sure, that a significant number of bond professionals are shorting Treasuries and buying riskier, less liquid corporate bonds with the proceeds.  This will one day end in tears (think:  Long Term Capital), but likely not in the near future.

currency

To the extent that 1 and 3 involve foreigners, who have to buy dollars to get into the game, their activity puts at least some upward pressure on the US currency.  The dollar has risen by about 2.4% over the past year on a trade-weighted basis, and by about 3% against the yen and the euro.  That’s not much.  In fact, I was surprised when calculating these figures how little the dollar has appreciated, given the outcry from the administration and its pressure on the Fed to weaken the dollar by lowering the overnight money rate. (My guess is that our withdrawing from the TPP, tariff wars, and the tarnishing of our image as a democracy have, especially in the Pacific, done much more to damage demand for US goods than the currency.)

high-yielding stocks as a substitute for bonds?

I haven’t done any work, so I really don’t know.  I do know a number of fellow investors who have been following this idea for more than five years.  So my guess is that there aren’t many undiscovered bargains in this area.

 

my bottom line

I’m less concerned now about the message low bond yields are sending than I was before I started to write these posts.  I still think the valuation mismatch between stocks and bonds will eventually be a problem for both markets.  But my guess is that normalization, if that’s the right word, won’t start until the EU begins to repair the serious fissures in its structure.  Maybe this is a worry for 2020, maybe not even then.

It seems to me that the US stock market’s main economic concern remains the damage from Mr. Trump’s misguided effort to resuscitate WWII-era industries in the US.  The best defense will likely be cloud-oriented cash-generating software-based US multinationals.  (see the comments by a former colleague attached to yesterday’s post).

 

 

 

 

 

shrinking global bond yields

valuing bonds   …and stocks

Conventional US financial markets wisdom–maybe glorified common sense–says that the yearly return on financial instruments should consist of protection against inflation plus some additional reward that varies according to the risk taken.  For stocks, the belief is that they should earn the inflation rate + six percentage points for risk annually; ten-year government bonds should return inflation + three percent.

If inflation is 2%+, this means the 10-year Treasury should have an annual yield of 5%+.

Stocks should have a total return (price change + dividend received) on average of 8%+ yearly.

last Friday

the 10-year

Last Friday, the 10-year Treasury yield broke below 2%, to an intra-day low of 1.95%!

Austria

Even weirder, across the Atlantic, the Austrian government is warming up to issue 100-year bonds yielding 1.2%.  Demand appears to be strong, possibly because its issue of century bonds in 2017 at a 2.1% yield is up in price by about 60% since.  Of course, it’s also true that many EU sovereign instruments are trading at negative interest rates–a result of central bank efforts to stimulate economic growth there.

Trumponomics

Odder still, but probably not that surprisingly, Mr. Trump is actively browbeating the Federal Reserve to lower interest rates further, despite the fact that virtually no domestic evidence is calling for further distortion to rates.  I say “virtually,” because there is one contrary–the administration’s policy on trade and immigration.  If there is a master plan behind that, I guess it’s what Mr. Trump believes is needed to assure his reelection.  One issue for him is that the price increases he has put on imported goods have offset almost all of the Federal income tax reduction the average American family got last year.  In addition, the seemingly arbitrariness and changing nature of Trump tariffs–plus the radio silence of Congress tacitly approving of the circus–appear to have slowed domestic capital investment significantly.  More forethought is likely out of the question for the administration   …hence Mr. Trump’s Rube Goldberg-esque call for counterbalancing monetary stimulus.

???

I’ll happily confess that I’m not a bond expert.  For what it’s worth, I don’t like bonds, either.  But the present state of affairs in the bond market–the absence of any return above protection from inflation– seems to me to say that money policy in the US and EU is still enormously stimulative, no longer effective and need of careful handling in extracting us from this situation.  The last thing we need is higher taxation through tariffs and even more distortion of yields.

 

What would make someone want to buy the proposed Austrian century bonds anyway?

…the greater fool theory, i.e., the idea I can sell it at a higher price to someone else (which certainly worked with the 2017 issue)?

…the fact that lots of EU government instruments sport negative yields, so this may be a comparatively good deal?

…I’m a bond fund manager and need coupon payments so my portfolio can pay expenses and management fees to myself?

…I’m shorting negative yield bonds against this long position?

 

global/demographic/government influences on yields

aging populations…

Another general principle:  as people get older and as they get wealthier they become more risk averse.  Put another way, in either situation people shift their investment portfolios away from stocks and toward bonds.

The traditional rule of thumb is that a person’s bond holdings should make up the same percentage of the total portfolio as his age in years.  The remainder goes into stocks.  For example, for a 65-year old, 65% of the portfolio should be in fixed income.  (I don’t think this is a particularly good rule, but it’s simple and it is used.)

What’s important is that the aging of the populations in the US and the EU (which is older than us) is a powerful asset allocation force.  In the US in 2000, for example, (according to the Investment Company Institute) investors held $276 billion in funds, of which 82% was in equity funds.  At the end of last year, the total was $681 billion, of which 40% was in equities.  Over that time, the amount of money in stock funds rose by 20%; bond funds went up by 10x, however; asset allocation funds, which hold both, had 6.5x their 2000 assets.

national economic policy

For as long as I’ve been around, the preferred tool of government economic management has been monetary I can be applied faster than fiscal policy   …and it leaves no fingers pointing at politicians if implement is painful or executed maladroitly.

The chief characteristic of expansive monetary policy is the suppression of interest rates.  The burden of adjustment falls squarely on the shoulders of savers, i.e. older citizens, and the poor, who have no ability to borrow to take advantage of the lower cost of money.

 

More tomorrow.