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October 13, 2015
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Bad News is Good News (For Now)
According to folklore, Grigory Potemkin – a Russian military leader and statesman – erected a
fake portable settlement along the banks of the Dnieper River in order to fool and impress
Empress Catherine II during her journey to Crimea in 1787. It was a façade intended to mask
or divert attention from shabby conditions. The “Potemkin Village” catchphrase is now often
used, typically in economics, to figuratively describe any creation built solely to deceive others
into thinking that some situation is better than it really is.
The Potemkin Village is exactly what comes to mind when I look at the economy and markets
today. While the stock market remains at bubble levels, home prices have rebounded to record
highs and the official unemployment rate has fallen to 5.1%, but things are not as they appear.
First, let’s talk about one of my favorite topics: the stock market. Since bottoming in 2009, the
stock market has been in one of the strongest bull markets ever. The S&P 500 has surged from
its March 2009 low of 666 to its May 2015 all-time high of 2,134. On the surface, one would
conclude that the economy is booming and corporate America is humming on all cylinders. Not
so!
First and foremost, the stock market is NOT the economy. Never has been… never will be. With
that said, one would expect a strong market to go hand in hand with strong economic growth.
Well the economy has been growing at close to 2% since the Great Recession of 2008. This is
very sluggish growth when considering that the Fed has pushed the pedal to the metal with zero
interest rates since 2008 and 24/7 money printing. Historically, the U.S. economy has averaged
3.5% real GDP.
So, if it is not the economy, then the stock market must be feeding off Corporate America’s
record revenues and strong profits. Wrong again. In fact, corporate revenue growth has been
quite unimpressive since 2009.
Weekly Relative Value
October 13, 2015
Since 2009, corporate revenue has only increased by a marginal 23%! Yet, the reported earnings
per share (EPS) of corporations increased by a total of 190%. How is it possible that earnings
could expand almost 9 times faster than revenue? Thanks to the Fed’s misguided and
accommodative policies (ZIRP) intended to boost business investment; ultra-low rates have led
corporate managers to employ “financial engineering” and “accounting shenanigans” to boost
earnings per share.
One of the primary gimmicks has been for corporations issuing debt to buy back their own stock.
The reality is that share buybacks create an illusion of profitability. If a company earns $0.90 per
share and has one million shares outstanding – reducing those shares to 900,000 will increase
earnings per share to $1.00. No additional revenue was created; no more products were sold, it is
simply accounting magic. Such activities do not spur economic growth or generate real wealth
for shareholders.
So instead of investing for growth, companies have used cash flow to buy their stock to create
the perception of growing earnings. As Carl Icahn recently said, “It's like taking steroids.
Everyone's happy to see an athlete jump high. But that type of earnings growth is not
sustainable.” This is especially true when companies with little earnings and lots of debt buy
back stock.
Buybacks Reach Record Levels
The most important driver of stock prices is earnings and expectations for earnings growth. And
during a time when valuations – e.g. the price/earnings ratio or PE – are stretched, earnings
growth is what keeps stock prices going.
As shown below, according to Generally Accepted Accounting Principles (GAAP) earnings
appear to have plateaued in Corporate America.
Weekly Relative Value
October 13, 2015
And as we enter peak earnings season Wall Street is preparing for the worst earnings season
since 2009, with Factset further noting that “if the index reports a decline in earnings for Q3, it
will mark the first back to-back quarters of earnings declines since 2009.” Equally significant,
revenues are set to tumble another 5%. Earnings per share are set to tumble 4.5%. With stock
valuations priced to perfection, it is unlikely that this ends well. There are many that suggest that
“this time is different” due to Central Bank stimulus and low interest rates; however, history
suggests this is unlikely to be the case.
Earnings are Slowing
Bad News is Good News (For Now)
Last week, like bulls in a China shop, equity markets went on a rampage just as weak data was
mounting up fast and warnings of another global recession were getting louder.
Citi economist Willem Buiter looks at the world landscape and sees an economy performing
substantially below potential output.
“… from an output gap that was probably quite close to zero fairly recently, continued
sub-par global growth is likely to put the global economy back into recession, if indeed
the world ever fully emerged of the recession caused by the global financial crisis.”
And it’s not just an economist from Citi. In fact, some of the most important financial institutions
in the entire world are warning about trouble times ahead. The International Monetary Fund
(IMF) is warning that the “dangerous over-leveraging” that we have been witnessing “threatens
to unleash a wave of defaults” all across the globe… “$3 trillion corporate credit crunch looms
as debtors face day of reckoning, says IMF.”
October 13, 2015
Weekly Relative Value
The Bank for International Settlements (the central bank of central banks) also issued similar
ominous warnings. The Bank for International Settlements believes interest rates have been too
low for too long, encouraging too much risk-taking in financial markets. All of them fear that
the global financial system is primed for a crisis.
Incoming high frequency data has also taken a clear turn for the worse. Even ignoring China,
industrial output in Germany, probably the most connected of world’s big economies due to its
high-end machinery and car exports, is at its lowest in a year. The last set of U.S. jobs and
manufacturing numbers were unambiguously grim. Russia is reeling and the IMF has just
forecast a pan-Latin American recession this year.
So, in light of the bad news the Dow-Jones Industrial Average rose over 1,000 points to close
over 17,000 for the first time since August. Wilshire Associates reckons that they tacked on
3.44% (approximately $800 billion) over the full week, based on the gain in the Wilshire 5000
index, their biggest weekly gain in nearly 12 months.
So with the economy slowing and revenues/earnings declining why has the stock market
remained so resilient?
We’ve been here before and it’s becoming tedious. But at least the equity market’s euphoric
reaction was entirely predictable. It’s quite simple. It’s because we are now back in a world
where “bad news is good news.” The weaker the data the higher the probability that the central
banks will provide more stimulus and rate cuts in the Euro zone, Japan and China; and further
push back long-awaited U.S. hikes.
On cue, last week Goldman made an audible call, instructing the Fed to substantially defer liftoff well into next year. As its New York based chief economist Jans Hatzius, informed clients:
October 13, 2015
Weekly Relative Value
“… a slowdown in output and employment may justify the Fed keeping the near-zero rate
policy for much longer, well into 2016 or potentially even beyond… further bad news on
output and employment could potentially result in quite a large shift in the monetary
policy outlook.”
The Bottom Line
The stock market may continue to rise, but our economy is weak, not strong. And it is the
strength of an economy that creates true wealth. Without a strong economy, no nation grows
wealthy or stays wealthy. Asset valuations are ultimately grounded in the economy, at least in
the long run. Rising employment, standards of living and financial asset prices accompany strong
economies. Without these pre-requisites, long-term wealth cannot be created.
Central banks’ ability to engineer an economic recovery ended a few years ago. Now they have
every incentive to continue to inflate financial asset prices as it is the only thing left that they can
fake. As such, central banks of the world are now engaged in a desperate and self-evident
scramble to keep the financial bubble they have inflated from collapsing upon itself. We are
living in a “Potemkin Village.” Again, things are not as they appear.
Yanking Down Yields
For years, pros across Wall Street have argued that interest rates have nowhere to go but up.
HSBC's Steven Major was one of the few forecasters to correctly predict that in 2014 bond
yields would fall and end the year lower. Once again, Major is going against the grain to say
yields will fall even further, though the Fed has maintained that it could raise short-term interest
rates this year.
Last week, he slashed his target yield on the 10-year Treasury benchmark for 2015 and 2016,
from 2.4% and 2.8% to 2.1% and 1.5%, respectively.
October 13, 2015
Weekly Relative Value
From the note:
“We believe the path of rate hikes, when and if they start will be shallow. Compared with
the Bloomberg median, our 10-year Treasury forecasts at 2.1% for end-2015 and 1.5%
for end-2016 are 38 basis points and 153 basis points lower, respectively. Indeed,
consensus expectations for the first Fed funds hike have been pushed into 2016, reflected
in futures prices. The 50 basis point two-year T.note forecast, made in August, is still in
place for end-2015 and into next year.”
More from Major:
As noted above, the thesis is more easing from ECB...
“Our conviction on ECB policy remaining accommodative beyond the end-2016 forecast
horizon is relatively high. Indeed, we think it likely that there will be more easing soon
(ECB & QE).”
... And less tightening, if any, from the Fed:
“Central banks did not forecast the persistently weak growth or recent decline in
inflation. So data dependency does not easily justify lifting rates from the zero-bound – it
might suggest the opposite.”
Major's conclusion:
“The U.S. is ‘turning European’, or is it Japanese? If the German Bund market has
been ‘turning Japanese’ perhaps the U.S. curve could ‘turn European’?”
More Talk of NIRP
Federal Reserve officials now seem open to deploying negative interest rates (NIRP) to combat
the next serious recession even though they rejected that option during the darkest days of the
financial crisis in 2009 and 2010.
“Some of the experiences [in Europe] suggest maybe can we use negative interest rates and the
costs aren’t as great as you anticipate,” said William Dudley, the president of the New York
Fed, in an interview on CNBC on Friday.
The following Bloomberg bullet summary (as the latest dot plot made abundantly clear) and,
according to Minnesota Fed member Narayana Kocherlakota, NIRP is in now definitively in the
playbook.
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KOCHERLAKOTA SAYS FED SHOULD CONSIDER NEGATIVE RATES
KOCHERLAKOTA: TAPERING ASSET PURCHASES LED TO SLOWER JOB
GAINS
October 13, 2015
From Kocherlakota’s speech:
Weekly Relative Value
“Indeed, to best fulfill its congressional mandates, the Committee should be
considering reducing the target range for the fed funds rate, not increasing it.”
And Bernanke told Bloomberg Radio last week he didn’t deploy negative rates because he was
“afraid” zero interest rates would have adverse effects on money markets funds – a concern they
wouldn’t be able to recover management fees – and the federal-funds market might not work.
But events in Europe over the past few years have changed his mind. In Europe, the European
Central Bank, the Swiss National Bank and the central banks of Denmark and Sweden have
deployed negative rates to some small degree.
“We see now in the past few years that it has been made to work in some European countries,”
Bernanke said.
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How can anything positive come from this?
Seriously, has anyone thought this through?
Hasn’t ZIRP done enough damage?
Can anyone show a clear example connecting the dots to show where negative interest
rates have stimulated an economy?
Can anyone clearly explain how charging an individual, institution or business to hold
deposits is in any way simulative AT ALL?
It defies common sense.
When Will We Escape ZIRP?
October 13, 2015
Understanding Velocity of Money
Weekly Relative Value
Why were the inflation hawks so wrong about quantitative easing? Why didn’t all the “money
printing” lead to commodity prices skyrocketing?
One answer is that while bank reserves were boosted, lending didn’t take off and there was no
uptick in the velocity of money – the speed at which capital zooms through the economy and
turns over. Absent velocity of money, QE could be looked at as either ineffective or actually
causing a deflationary environment, where capital is hoarded and everyone is too petrified to risk
it on productive endeavors.
While money consists of many different assets, you can – as a metaphor – think of money as
consisting entirely of dollar bills The velocity of money is a measure of how rapidly (on average)
these dollar bills change hands in the economy.
Nominal spending in the economy would then take the form of these dollar bills going from
person to person. If there are not many dollar bills relative to total nominal spending, then each
bill must be involved in a large number of transactions (the greater the velocity, the stronger the
economy and higher the inflation rate).
In America, Japan and the Eurozone velocity has continued to decline since the financial crisis in
2008. Indeed, U.S. money velocity is now at a six-decade low.
Velocity is Lowest Ever
October 13, 2015
Weekly Relative Value
Market Outlook and Portfolio Strategy
Ignore the stock market’s celebration of weaker than expected payrolls. Instead, investors should
focus on the rapid decline in U.S. inflation expectations since the Fed meeting – even now
converging to dire Eurozone levels! Far more interesting is the continuing slide in U.S. breakeven inflation expectations. The measure for five-year expectations, in five years’ time, has now
decisively fallen below the January low and the spread verses the Eurozone (now fallen to only
20 basis points against 60 basis points last October).
The collapse in inflation expectations tells us that the market believes the central banks, despite
their monetary profligacy, are failing to prevent the western economies from turning Japanese.
Inflation Expectations Decline
And apparently the markets have taken notice. Last week, for the first time ever the U.S. sold
three-month Treasury bills at a yield of absolute zero – 0.00%! Given that the European Central
Bank charges banks a fee to stash their cash there, lending to Uncle Sam for nil isn’t, apparently
in the eyes of some, unreasonable.
Looking forward, sup-par economic performance is the most likely outcome for the year. Recent
data points to a very weak third quarter with growth probably coming in less than 1%, supported
by the prescient Atlanta "nowcast" model. The annual run rate for GDP suggest growth below
2%, thus entering 2016 on slowing momentum.
Another thing to keep a close eye on is inventories. As witnessed in the latest wholesale sale
report, inventories are rising fast with the inventory to sales ratio clearly in recessionary
territory. In fact, as we show in the graph below, the value of inventories over sales has
never been higher.
October 13, 2015
There can be little doubt that the massive, unprecedented surge in inventory accumulation
(which counts positively to GDP) will eventually be liquidated.
Weekly Relative Value
When it does, the U.S. may enter recession and a world recession will be upon us again.
Inventory Levels Sky High
In addition, time is getting ripe for another down cycle. The current expansion has been ongoing
for 75 months and is by that the fourth longest on record. The business cycle has not been
outlawed. It is a matter of when, not if.
Recovery is "long in the tooth"
Since the Fed has intervened via ZIRP and QE equity markets, instead of trading to economic
reality, they have traded on the bad news is good news meme. Bad news brings the promise of
more stimulus in terms of QE or lower rates. This fuels the gambling casino on Wall Street, but it
is clearly not healthy or sustainable.
Weekly Relative Value
October 13, 2015
I believe we are entering an environment with high market volatility, as the so-called central
bank put (more QE or lower rates) is less powerful and may not be as effective anymore. In other
words, bad news may in fact become bad news. Frankly, bad news is supposed to be bad news
and this should lead to honest price discovery and a healthier market than before. Yet, the
adjustment back to normal is not going to be, easy.
Capital preservation remains key!
In September, the Federal Reserve passed on what would have been its first interest-rate hike in
nine years, as concerns about the labor market and global weakness weighed on voting members'
minds.
Since August 24, when the Fed Chair declared, ‘Most of my colleagues and I anticipate that it
will likely be appropriate to raise the target range for the federal funds rate sometime later this
year,” central-bank officials and many economists cling to the idea that liftoff could take place
before year end. I will believe it when I see it. The Fed can say what they want, but the entire
global central bank mantra is about chasing rates lower. They are afraid of bursting the bubbles
they have created. Growth is too anemic, inflation too low and debt too large to entertain higher
rates regardless of what is said.
And the market agrees. Despite the Fed prognostications, the implied odds of a rate hike have
only gone downhill. The probability of a rate hike in 2015 implied by federal funds futures has
slipped to 35%.
Markets are losing faith in central bankers and the efficacy of monetary policy is also under
siege. Market participants have started to question the effectiveness of monetary policy, with
good reason.
October 13, 2015
Stay Long Bonds.
Weekly Relative Value
In closing, the bull market in bonds that started 34 years ago continues. Buying on bouts of
weakness remains our recommended entry to the market.
In terms of portfolio strategy, we continue to favor investing excess cash reserves further out the
yield curve. Short to intermediate ladder strategies (CDs, bank notes, agencies) are appropriate in
today’s market. Meanwhile, we believe that high excess cash reserves will continue to negatively
impact income and net interest margins.
In terms of identifying relative value, please click here for the Weekly Relative Value Analysis.
October 13, 2015
Weekly Relative Value
More Information
For more information about credit union investment strategy, portfolio allocation and security
selection, please contact the author at [email protected] or (800) 7822431, ext. 2753.
Tom Slefinger, Senior Vice President, Director of Institutional Fixed Income Sales, and
Registered Representative of ISI, has more than 30 years of fixed income portfolio management
experience. He has developed and successfully managed various high profile domestic and
global fixed income mutual funds. Tom has extensive expertise in trading and managing virtually
all types of domestic and foreign fixed income securities, foreign exchange and derivatives in
institutional environments.
At Balance Sheet Solutions, Tom is responsible for developing and managing operations associated
with institutional fixed income sales. In addition to providing strategic direction, Tom is heavily
involved in analyzing portfolios, developing investment portfolio strategies and identifying
appropriate sectors and securities with the ultimate goal of optimizing investment portfolio
performance at the credit union level.
Information contained herein is prepared by ISI Registered Representatives for general circulation and is distributed for general
information only. This information does not consider the specific investment objectives, financial situations or particular needs of
any specific individual or organization that may receive this report. Neither the information nor any opinion expressed constitutes
an offer, or an invitation to make an offer, to buy or sell any securities. All opinions, prices, and yields contained herein are
subject to change without notice. Investors should understand that statements regarding future prospects might not be realized.
Please contact Balance Sheet Solutions to discuss your specific situation and objectives.