August 23, 2019
By Steve Blumenthal
“When real yields are low or negative, investors’ returns are not commensurate with risk,
so investment falls along with productivity gains and growth prospects.”
– Lacy Hunt, Ph.D. and Van Hoisington,
Hoisington Investment Management Company
I begin this week’s OMR highlighting important points from Lacy Hunt and Van Hoisington’s most recent client letter. Bottom line: I think they have it right and it serves as a nice intro into the “magic money tree” (a/k/a Modern Monetary Theory “MMT”) podcast discussion I had this week with Avalon Advisors’ Chief Economist, Sam Rines. You will find that link below.
This from Lacy and Van:
- Before the world’s economies became so heavily indebted, the movement of nominal long-term government bond yields followed some fairly broad-brush strokes.
- Fluctuations in inflationary expectations, over time, dominated the trend in yields. Expectations, in turn, reflected the vicissitudes of the business cycle and investor reaction to government policy changes and investors’ understanding of how those actions influence the economy.
- With the current global experience of more than two decades of subnormal economic growth in the face of extreme over-indebtedness, numerous cases of sustained historically low levels of real yields have come into focus and the following analysis indicates this recent pattern is likely to persist.
- If debt levels as percentage of total output continue higher, then investors will likely face even lower future real yields. Additionally, as inflation recedes in response to softening economic conditions, which the Fed acknowledged again in its June meeting, then both determinants of long government bond yields – the real yield and inflationary expectations – point toward noticeably lower nominal yields.
- When real yields are low or negative, investors and entrepreneurs will not earn returns in real terms commensurate with the risk.
- Accordingly, the funds for physical investment will fall, and productivity gains will continue to erode as will growth prospects.
- In the past five years, when nominal interest rates were slightly negative in Japan and Germany, real yields were even more negative since modest inflation continued.
- In each of these cases, negative real rates have been no panacea for the growth problems. Indeed, the span of sustained poor economic performance has increased.
- Now, evidence has emerged that the U.S. real rate, while still positive, is declining and that investors here are being forced to accept lower real yields similar to investors in foreign markets.
- The implication: decreased capital returns will prolong the period of poor economic growth in the United States, as has been the case in Japan and Europe. If the solution to the subnormal growth is an even faster acceleration in debt, then this cycle will continue to repeat.
The bottom line is this:
- Extreme over-indebtedness produces subnormal economic growth, reducing inflation expectations and thus reducing real yields too.
- This helps explain why real per capita GDP rose only 1.4% per annum in this expansion, the poorest growth rate since 1950.
- Recessionary forces may be advancing faster than is generally recognized. The yield curve has historically started to steepen at the start of recessions.
- Velocity of money appears to have fallen sharply in the second quarter. This will greatly reduce the Fed’s efforts to boost growth.
My friend, Patrick Watson from Mauldin Economics, summed it up this way: “Debt, economic growth, productivity and real yields form a vicious cycle. Higher debt levels produce lower growth and declining yields, which further discourages investment. This means lower real yields won’t have the same stimulus effect they would if debt levels were significantly lower. A mild recession will likely push real interest rates below zero. This is bullish for bonds but harmful in other ways.”
What will end this current deflationary cycle? New tools (a combination of monetary and fiscal) will be employed that will reset the global macroeconomic deck, but we are not yet at that place. Which brings us to my podcast conversation with Sam Rines from Avalon Partners. We talked about the Fed, QE and MMT. Just what is MMT? Think of it like a “magic money tree” in your backyard or a money printing press in your garage. Really cool if you could have one but it comes with consequences. For a country, think about the “make America’s [pension] plans great again” MMT-funded campaign (print and fund). Think about a grand U.S. infrastructure “fix our highways and bridges” campaign (print and fund). Think U.S. government deficit funding (print and fund). Wait, that is already happening.
We don’t yet know where this will go, but solving for the seemingly impossible is inevitable. There is no other choice but to do something and MMT is likely that something. We are nearing next moves. Politicians can easily embrace the concept, yet it opens the door to moral hazards and, like an addictive drug, where does it stop? In the end, there will be inflation. But as Sam and I discussed, that day is a long way from today.
The World has “Economic Flu” – or Something Worse
Around the world there is now $17 trillion in negative interest rates. Two weeks ago it was $15 trillion. Governments hoping that dropping rates below zero will force you to spend your money. Invest in a government bond and they pay you an interest rate. Invest in a negative-yielding government bond and you pay the government for that privilege. Backwards… a sickness. Governments are pushing on a string. They are starving savers; they are starving pension plans. But the beat goes on.
Global Bond Yields – August 21, 2019:
Japan -0.24%, U.S. 2-year Treasury Note 1.54%, U.S. 10-year Treasury Note 1.57%, U.S. 30-year Treasury Bond 2.05%, German Bunds -0.68%, German 30-year -0.30%, France -0.41%, Italy 1.33%, Turkey 15.92%, Greece 2.00%, Portugal 0.12%, Spain 0.09% and UK Gilts 0.46%. Hat tip to Armstrong Economics.
The best looking horse in the glue factory is the United States. But glue factory nonetheless. There is a path forward, it requires laws to be amended and like it or not… MMT is coming. Our job is to adapt.
Grab a coffee and find your favorite chair. My discussion with Sam is about MMT and we discuss a few ideas around investment positioning (hint: look to high dividend payers and value stocks for example). You’ll find the link below. I do hope you enjoy the 30-minute conversation (perhaps put on your sneakers and get out for a short walk). Opportunities abound. Stay optimistic… We’ll figure this out together.
If a friend forwarded this email to you and you’d like to be on the weekly list, you can sign up to receive my free On My Radar letter here.
Included in this week’s On My Radar:
- Sam Rines-Steve Blumenthal Podcast on MMT
- Hoisington Investment Management Company – Quarterly Review and Outlook
- Trade Signals – Don’t Fight the Tape or the Fed: Neutral Signal
- Personal Note – Back to School
Sam Rines-Steve Blumenthal Podcast on MMT
Here is the link to the podcast or just click the orange button below. Enjoy!
Hoisington Investment Management Company – Quarterly Review and Outlook
Here is the link to the Hoisington Quarterly Review letter.
Bottom Line: Debt, economic growth, productivity and real yields form a vicious cycle. Higher debt levels produce lower growth and declining yields, which further discourages investment. This means lower real yields won’t have the same stimulus effect they would if debt levels were significantly lower. A mild recession will likely push real interest rates below zero. This is bullish for bonds but harmful in other ways. Hat tip to Patrick Watson of Mauldin Economics.
Trade Signals – Don’t Fight the Tape or the Fed: Neutral Signal
August 21, 2019
S&P 500 Index — 2,919
Notable this week:
Market Commentary: We believe the market is forming a top and a re-test of the December 2018 low at 2,300 in the S&P 500 Index is probable. Nineteen out of the last 19 times the U.S. stock market “V” bottomed and rallied and the low was tested in some form. That has yet to happen since the December 24, 2018 low and subsequent rally. Three narratives have supported the stock markets: A directional change in Fed policy (the Powell Pivot), hopes for a trade truce with China and corporate share buybacks. Fed policy has shifted, yet history tells that the Fed is generally slow to cut and additional cuts follow as does recession. We believe that reality will become evident in the months ahead. The China-U.S. trade narrative has shifted. We don’t believe there will be a deal. Trump will try to kick the optimistic “making progress” can down the road or he will “about face” entirely. November 2020 is fast approaching.
Further, we see Trump’s trade attention turning to Europe. A hard Brexit looks like the probable outcome. There is a shake-up in the global system. The global economy is slowing, much of Europe is in recession. Felix Zulauf said it well in a recent research letter, “The driving force of declining bond yields around the globe is the slowing world economy, a structural deflationary bias, and ill-guided government policies.” Finally, according to S&P Dow Jones, since May this year corporate share buybacks are slowing. Corporations have been the dominant buyer, supporting equity prices. While their corporate cash levels remain high, corporate debt levels relative to GDP have never been higher and it appears boards of directors are growing cautious.
$17 trillion in negative interest rates globally is a sign of significant economic illness. We expect the Fed, the ECB, the JCB and China to continue to cut interest rates over the coming months. The U.S. and global equity markets sit in a high risk period. As mentioned above, we believe a re-test of the December 2018 low at 2,300 in the S&P 500 Index is probable between now and January 2020. The Fed will respond aggressively, but it is becoming clear that they are “pushing on a string.” Some new form of central bank QE policy will be created, so we expect a floor to the downside. We believe the next 10 years will look completely different than the last 10 years. A high volatility environment that will favor active management, trading strategies, value investing, dividend growers and balanced index structures over today’s popular cap-weighted processes. A period that will look more like 2000-2010 than 2010 to present.
The U.S. stock market is short-term oversold and extreme investor pessimism supports a bounce. Equity markets remain overvalued to extremely overvalued and well above historical trends. Such readings paint a low forward return probability over the coming five to 10 years. At best, we see zero price gains and investors earning the dividend yields only. Call it 2% before inflation. Trade and currency wars are disruptive for markets and economies. A shift in the global supply chain is coming. Buckle up.
Market Trends: Despite our bearish fundamental view, currently all of our equity market trend signals, while weakening, remain in buy signals. The Zweig Bond Model remains in a buy signal, suggesting higher bond prices. The HY trend is in a sell signal; however, prices have stabilized and are beginning to trend higher. Stay tuned. Notable this week is the signal change in the Don’t Fight the Trend or the Fed indicator. It moved from a bullish +1 reading to a neutral “0” reading. My favorite short-term investor sentiment indicator is in the “extreme pessimism” zone (which is generally short-term bullish for equities). The NDR Crowd Sentiment data (an intermediate-term indicator) is neutral. The trend in Gold remains bullish. The most recent signal has been outstanding. The indicator dashboard is next, followed by the updated charts with explanations below.
Not a recommendation for you to buy or sell any security. For information purposes only. Please talk with your advisor about needs, goals, time horizon and risk tolerances.
Click here for this week’s Trade Signals.
Personal Note – Back to School
“Anything worthwhile takes time to build.
We all want success now, but that’s not how success works.
After all, if we had immediate success, we wouldn’t build the character we need to sustain true success.
The struggle, adversity, triumphs, and victories are all part of the building process, and we must embrace all of it.”
Jon Gordon, The Carpenter (2014)
The drive to Penn State is just 2½ hours. Game plan: move sons Matthew and Kyle into their apartments. School starts on Monday. After a few phone calls and podcasts, I blinked and we were there. Three cars (yes, three) stuffed with stuff. The move-in was surprisingly swift. Ugh, the apartments are old, dirty and well – the word “dump” comes to mind. But they are their dumps and they are thrilled.
After a fancy pizza dinner and a visit to Walmart for groceries, mops, cleaning supplies and other apartment things, I reversed course and arrived home late last night tired but happy. I sure hope my kids read the above quote. Head down, work hard and build something that lifts your heart. “Anything worthwhile takes time to build.”
Travel picks up in September, though I’m not yet sure of where or when. The dog days of summer are on my mind. Here’s wishing you an ice cold beer, a fine glass of wine and something fun on your schedule. I’m not sure about you but I don’t yet want to let go of summer.
Have a great weekend!
Best regards,
Steve
Stephen B. Blumenthal
Executive Chairman & CIO
CMG Capital Management Group, Inc.
Stephen Blumenthal founded CMG Capital Management Group in 1992 and serves today as its Executive Chairman and CIO. Steve authors a free weekly e-letter entitled, “On My Radar.” Steve shares his views on macroeconomic research, valuations, portfolio construction, asset allocation and risk management.
Click here to receive his free weekly e-letter.
Follow Steve on Twitter @SBlumenthalCMG and LinkedIn.
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