Bad Omens

John Mauldin

 Jul 09, 2013

We have clearly been in a recent run of higher interest rates, with a looming "threat" that there might be less quantitative easing before the end of the year. It would appear now that Bernanke wants to leave his successor to implement what everyone knows must be coming at some point: a return to a normal interest-rate environment. While rising interest rates are bad for me personally (for another four months), a return to normalcy would be good for our futurethough the transition is likely to be bumpy.

With this in mind, I offer this week's Outside the Box from Louis and Charles Gave. In a brief essay entitled "Bad Omens," they note:

… if the recent global equity market sell-off can be laid at the feet of the 100bp move higher in US bond yields, it is hard to know how another 50bp increase in real rates will be digested.

US investors might not have noticed, but there is carnage scattered here and there on the world's markets, and not just the equity markets. The central banks of the world, in their furious attempts to promote stability through easy-money policies, have cooked up a witches' brew of instability of unknown quantity and contents. There is no set formula for this concoction; they are making it up as they go along. Anything that seems to calm the storm momentarily becomes the order of the day.

Bernanke hints at the mere possibility of less easing (not tightening, God forbid!), something that we all know must happen at some point, and the market throws up and half a dozen Fed governors go on the air to say "Not reallymaybe … we are going to be cautious … we'll go slowno one wants to do anything rash" – etc. It was almost comical.

Thus we can expect a volatile summer (as the interns man the trading desks), and I think you will find the Gaves' insights useful.

I am somewhat better, though still weak, but I'm glad to be home where I can pause and rest as necessary. I have not been down this long since I was a kid. For all those years of good health I am grateful, and I hope to go another 50 years without problems like the ones I've had this week.
In the grand scheme of things, there are so many who are having to deal with so much more. I am a lucky man.

I feel I should have warned my readers about the rise in interest rates. Rates have risen since just about the day that I irrevocably committed to a large mortgage which I cannot lock in until construction is done. The interim loan rate is quite cheap, but I am made acutely aware of what rising interest rates can do to a home payment, since I must go to more conventional financing within a year. And hedge in yen.

The weather here in Texas is abnormally nice for July. Instead of the typical 100s, highs are in the low 80s, at least in the shade. If it was this way all the time, our problem would be dealing with the tax refugees from California and New England. Have a great week.

Your watching his new place begin to take shape analyst,

John Mauldin, Editor
Outside the Box

Bad Omens

By Louis Gave & Charles Gave

In late May we published a debate piece on the near-term outlook for equity markets. Since then, emerging markets have once again lived up to their name by proving themselves hard to emerge from during an emergency (in USD terms, Brazil is down –35% year to date while Chinese valuations are back to 2008-crisis levels); for their part, European and US equity markets have pulled back, while the only salvation has come from Japan (the one market where it’s possible to find attractive valuations, accelerating economic activity and liquidity growth feeding off a Tour de France vitamin cocktail). But is this a case of Japan being the best looking horse in the glue factory?

In the following paper, we aim to review a number of signs from equity markets that look somewhat ominous. Needless to say, we welcome any feedback on the below.

The question at hand: is this a break-out?

The chart over-leaf traces the relative performance of the S&P 500 against long-dated bonds since the Asian Crisis in 1997. Since then, the world has experienced a series of deflationary shocks, each of which has been met by more activism from the Fed and other central banks: i.e.: lower rates and higher monetary base growth.

And each time, the excess money allowed for the rise in a few asset classes (TMT in the late 1990s, housing and financial intermediaries in the mid 2000s, commodities, fixed income instruments and emerging markets in the late 2000s...). But each time, the asset price rise was followed by an equity market bust; begging the question of whether the bust that seems to be unfolding in emerging markets is now the third iteration of a movie every investor has seen before (and which few have enjoyed)? Or whether the recent correlation between bonds and equities indicates that the repeated deflationary shocks are a thing of the past and nominal GDP growth will accelerate from now on? Could we be at a structural turning point?

1– A first bad omen: fewer markets rising

In the chart below, we take the top twenty equity markets in the world and compile a diffusion index that shows how many rose in the previous six months, against how many fell. So when the grey bar is at +20, global equity investors have made money in every major market; when the index reads –20 they found nowhere to hide.

And when the number is in negative territory, it simply means that more markets have fallen than risen in the previous six months. The red line is the performance of the S&P 500. Since 1992, we have had 14 occurrences in which more stock markets were falling than rising. In 10 of these 14 occurrences, the S&P500 fell by at least –10%. In the other 4, the S&P 500’s performance hovered between 0% and –10%. As things stand, the S&P 500 has recorded a double digit rise in the past six months, a major divergence.

2– Another bad omen: collapsing silver prices

Unfortunately, it’s not as if, lately, equity markets have been the only place to lose money. Indeed, as every gold bug has rediscovered in recent months, precious metals have again proven that they are anything but a safe-haven. Still, drops of 30% or more in silver prices do not happen that often: looking back at the past 100 years, such drops have only occurred 11 times. And interestingly, each one of these massive declines marked a significant change in the world financial system.

To cut a long story short, the investment rules after large declines in precious metals were almost always totally different from the rules which prevailed before the fall. More worryingly, each such decline was accompanied by a massive recession/depression somewhere in the world and almost every time by a recession in the US (grey shaded areas), the only exception being 1983-1984 when the Latin American depression did not trigger a US recession but instead a collapse in oil prices.

3– Beyond stocks and precious metals

Let us imagine a pension fund whose assets are invested conservatively with 40% in global fixed income, 40% in global equities, 10% in the world’s largest hedge funds (Bridgewater, Man-AHL, AQR...), 5% in gold and 5% in private equity. Leaving aside the private equity illiquid pocket, our pension fund will have basically lost between 5% and 15% of its assets across the board in just a few weeks.

Following these widespread losses, will our pension fund look to a) increase its risk and average down on the more beaten-up asset classes (i.e.: emerging market equities) or b) reduce its risk and use the recent rise in yield to immunize liabilities (or reduce its portfolio’s volatility)? In a world directed by VaR measures, CAPM models, and CYA boards, is that even a question?

4– Falling inflation expectations

Not that the imagined pension fund in question would automatically be wrong in increasing its fixed income allocation. After all, inflation expectations in the US (and almost everywhere) are falling like a stone, implying that fixed income instruments now offer a much higher real yield than the recent rise in nominal interest rates might imply:

And these collapsing inflation expectations bring us to the chart above for, since the Asian Crisis, each time US inflation expectations fell below 1.5% (i.e.: a deflationary shock), US equities took a beating. That [doted] line in the sand is approaching fast. Just as worryingly, the collapse in inflation expectations, combined with the rise in nominal rates, means that the recent rise in US Baa real bond yields is the biggest one witnessed since the start of 2009when bond markets were massively overbought.

Of course, one could argue that the recent rise in yields is nothing to worry about; that it is just the side effect of the air coming out of the bond market bubble. Unfortunately, recent weeks have shown that such an attitude may be too carefree as most assets have reacted badly to falling bond prices. Indeed, if the recent global equity market sell-off can be laid at the feet of the 100bp move higher in US bond yields, it is hard to know how another 50bp increase in real rates will be digested? Looking at the bond vs equity trade-off today, it is easy to imagine Woody Allen saying “we have reached a cross-road. One way (rising yields?) leads us to despair and annihilation, the other (falling yields?) to certain death. I hope we choose wisely.”


So here we are, with:

China, the single biggest contributor to global growth over the past decade, slowing markedly.

World trade now flirting with recession.

OECD industrial production in negative territory YoY.

Southern Europe showing renewed signs of political tensions (i.e.: Portugal, Greece, Italy...) as unemployment continues its relentless march higher and tax receipts continue to collapse.

Short-term interest rates almost everywhere around the world that are unable to go any lower, even as real rates start to creep higher.

Valuations on most equity markets that are nowhere near distressed (except perhaps for the BRICS?).

A World MSCI that has now just dipped below its six month moving average.

A diffusion index of global equity markets that is flashing dark amber.

Margins in the US at record highs and likely to come under pressure, if only because of the rising dollar (most of the US margin expansion of the past decade has occurred thanks to foreign earnings—earnings that may now be challenging to sustain in the face of a weaker global trade growth and a stronger dollar).

Lackluster growth? Falling margins (outside of Japan)? Rising real rates? Unappealing valuations (outside of the BRICS)?... Perhaps these make up the wall of worry that global equities will climb successfully. After all, if the British and Irish Lions can win a rugby series in the Southern hemisphere, while a Scotsman wins Wimbledon, then nothing is impossible. Though perhaps the simpler explanation to the above growing list of bad omens was formulated by Claudius who said that “when sorrows come, they come not as single spies, but in battalions”.

Markets Insight

July 10, 2013 9:13 am
Markets Insight: Enter the sci-fi world of central bank action
Risk/return expectations turned on head by artificially low interest rates
In some science fiction movies, humans enter a distorted zone and undergo changes that affect them both in that strange world and in the more traditional one. Well, behavioural change is what happened to the traditional capital structure during its sojourn in the realm of zero-bound interest rates. And the acquired anomalies may be materially tested as interest rates gradually normalise, particularly if global economic growth disappoints again.
In the traditional characterisation of the capital structure, the risk-return mix ranged from secured fixed income obligations (low risk, low return potential), to unsecured bonds, hybrid securities and, of course, equities (high risk, high return potential).

Moreover, the further the two segments were from one another in the capital structure, the lower the correlations between them.

For securities at opposite ends of the capital structure, such as high quality government bonds and equities, the correlations were negative, thus providing for inbuilt risk mitigation for well-diversified asset allocations.

For quite a while, capital structures behaved accordingly. However, things changed in the aftermath of the 2008 global financial crisis as governments and central banks interfered more in the functioning of financial markets.

By choosing where in the capital structure to intervene directly and what to influence, the official sector altered the risk-return characteristics.

In addition, by forcing interest rates to artificially low levels and keeping them there, they changed the distribution of expected returns for individual securities, as well as the risk mitigation characteristics of diversified portfolios.

Initially, the overall impact was generally investor-friendly as prices of many financial assets were pushed higher. The bad news related to what followed.

As a simple illustration, consider the 5-year US Treasury note issued at the end of March. A low coupon and relatively modest yield curve roll-down meant the most investors could reasonably expect at issuance was a total return of 2.7 per cent over the subsequent two-year period.

If, however, five-year rates were to go up by 70 basis points, which in fact they did over the next three months, the bond was already 3.25 per cent under water (as of the June 25 close), altering the risk/return outlook.

Such initially asymmetrical return distributions were amplified as investors ventured further out on the yield curve and took on greater credit and liquidity risks. For example, Apple’s 30-year bond issued at the end of April came at a yield of 3.88 per cent. With the subsequent repricing of both interest rate and credit risk, the bond was down 12 per cent at quarter end.

The explanation for this asymmetrical distribution was simple: the closer interest rates and credit spreads got to the zero-bound, the smaller the upside and the greater the downside. This dynamic was exaggerated when securities were artificially compressed by experimental central bank policy.

Under these circumstances, investors’ perception of the capital structure inverted. A low-yielding government bond with a price essentially capped at par offered limited returns and high price risk. In contrast, equities were seen as providing the potential for large price appreciation, and this lack of price cap compensated for the downside risk.
This zero-bound aberration led some analysts to characterise equities as “safer” than bonds. Some even claimed they were the “new risk-free asset”. And the impact on asset allocation models could be quite dramatic.

In pursuing the investment implications today, investors would be well advised to remember that the postulatedsafety” of equities, whether in absolute or relative terms, is state-specific. Absent consistently higher multiples, it works only if corporate revenues and profits increase accordingly and, therefore, if economic growth does not disappoint.

This qualifier is an important one, especially in a world where US growth is still recovering, Europe is in recession, China is slowing and other emerging countries are struggling to navigate fluid global conditions. Also, with policy responses remaining narrow, the past few years of monetary policy experimentation may just have borrowed growth from the future rather than created conditions for incremental expansion.
In sum, the notion of the inverted capital structure is a construct of the abnormal zone near the zero bound. When central bank activity mattered a lot more than fundamental economic activity, perhaps this new logic was not such an anomaly. Now, though, investors are looking at a different outlook; and if economic activity disappoints, inverted capital structures could prove costly illusions.

Mohamed El-Erian is chief executive and co-chief investment officer of Pimco

Copyright The Financial Times Limited 2013. 


Updated July 9, 2013, 12:17 p.m. ET

IMF Cuts Global Growth Outlook

Prospect of the U.S. Fed Unwinding Easy-Money Policies Is Aggravating Emerging-Markets Slowdown


     WASHINGTONThe International Monetary Fund Tuesday cut its global growth outlook for this year and next, saying the prospect of the U.S. Federal Reserve unwinding its easy-money policies is aggravating a slowdown in emerging markets.
    The IMF's souring emerging-market forecast comes on top of a deepening euro-zone contraction and a downward revisión of U.S. growth as federal-budget cuts bite longer than the fund originally forecast.
    The IMF cut its growth forecast for this year and next by 0.2 percentage point from its last assessment in April. It now expects 2013 growth at 3.1% and 2014 output at 3.8%.

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    The IMF said downside risks to global growth prospects still dominate. "While old risks remain, new risks have emerged, including the possibility of a longer growth slowdown in emerging market economies," the IMF said in an update of its World Economic Outlook.
    Countries such as China, Brazil and India are facing lower potential growth, slowing credit and tighter financial conditions as investors consider pulling their cash out of emerging markets in favor of higher returns in the U.S., where interest rates are rising. The fund downgraded emerging-market-growth expectations by 0.3 percentage point, forecasting 5% output this year and 5.4% in 2014. Brazil, China and Russia were hit with some of the largest growth cuts.
    The Fed sparked a torrent of capital-flow reversals last month as officials outlined a possible exit plan from the bank's cheap cash policies. The prospect of higher interest rates caused investors to restructure their portfolios, stoking volatility in currency, bond and equity markets around the globe.
    The IMF hopes those market gyrations will cool. "They largely reflect a one-time repricing of risk due to the changing growth outlook for emerging market economies and temporary uncertainty about the exit from monetary policy stimulus in the U.S.," the fund said.
    But it cautioned that underlying vulnerabilities in emerging markets could lead to more portfolio shifts, particularly if interest rates continue to rise. "The results could be sustained capital-flow reversals and lower growth in emerging markets."
    Top fund officials have recently criticized the Fed for not communicating clearly enough about its exit plans. The IMF, which acts as the world's emergency lender and economic counselor, said the U.S. central bank should keep its $85 billion-a-month cash injections going until at least the end of the year, and only slightly let up on the easy-money accelerator in early 2014.
    The slowing growth and capital outflows put emerging-market policy makers in a tough spot. Weaker output should call for easy-money policies. But lower interest rates won't help authorities stem a flow of investment out of their economies that can deflate currencies and collapse markets.
    With weaker growth prospects and potentially overinflated markets, emerging markets face the threat of financial instability, the IMF warned. For example, many economists warn that China's real-estate market could crash after years of hyper-investment.
    Meanwhile, the euro zone faces a worsening contraction. The IMF says the currency union is now expected to contract this year by 0.6% before a 0.9% rebound next year. Monday, the fund urged the European Central Bank to cut policy rates and use other tools to spur lending.
    The IMF also downgraded U.S. growth prospects as it now expects automatic federal budget cuts won't be replaced with a more-gradual pace of deficit reduction. The fund sees the U.S. economy expanding at 1.7% this year and 2.7% next year.
    Two bright spots in the report are higher growth rates for Japan and the U.K. The Bank of Japan's 8301.JA 0.00% aggressive easing efforts pushed the Asian economy's forecast up by half a percentage point this year to 2%. And although the IMF earlier this year criticized London's austere approach to its government balance sheet, those policies have helped advance the U.K.'s growth outlook up to 0.9% this year.

    Copyright 2012 Dow Jones & Company, Inc. All Rights Reserved

    July 8, 2013 6:35 pm

    The Fed must change itself as well as its policies
    The US central bank must retreat from QE and reform its structure, says Henry Kaufman
    The Federal Reserve building, Washington DC©Bloomberg
    The Federal Reserve building, Washington DC
    The US Federal Reserve may soon have a new chairman – and what a time to take over. Assuming Ben Bernanke leaves his post this year, his successor will inherit a serious policy challenge: disengaging from quantitative easing.
    Returning to more traditional monetary policy will be tricky. First, there is no precedent in the Fed’s 100-year history. Has there ever been a period in which the US central bank and its leading counterparts worldwide have simultaneously pursued QE against a backdrop of economic faltering and uncoordinated fiscal policies?
    Second, a prerequisite for ending QE is considerable evidence of a return to normalcy in economic and financial growth. Despite the good news suggested by last week’s jobs data, right now that is not yet fully visible, either in the US or abroad.
    Moreover, were QE to be halted now, it would be against uncertainties about the effective functioning of larger financial conglomerates. The Dodd-Frank legislation did not resolve the too-big-to-fail problem. The Fed failed to recognise that abandoning the Glass-Steagall Act in the 1990s would accelerate industry consolidation and create more too-big-to-fail institutions.
    The resulting behemoths stand in the way of returning mortgage funding to the private sector. Imagine for a moment that federal financing institutions such as Fannie Mae and Freddie Mac were somehow dissolved. As the US financial system is now structured, most new mortgage securities would be held at a handful of conglomerates deemed too big to fail.

    All in all, the Fed faces a serious policy conundrum. Mr Bernanke put the recovery in jeopardy late last month with his pronouncements about withdrawing from QE. His timeline is based entirely on the Fed’s economic projections, which in recent years have proved wide of the mark.

    But continuing QE may encourage unsustainable financial practices. Monetary officials have issued warnings about the emergence of speculative activities that rely on the Fed’s asset buying. Whether the Fed can deal with them selectively is uncertain. If it does, it will be a big departure from policy approaches of recent decades. A new chairman, however, should take on another big task; the Fed’s structure, as it has evolved in the past century, does not help it meet its challenges head-on.

    The location of its 12 district banks, for example, is outmoded. A heavy presence in the Midwest and northeast made sense in the early 20th century as the US was still industrialising. It grew anachronistic as population and economic activity burgeoned in the west and south. Californiaitself the world’s seventh-largest economy – and six other western states are served by a single district (or Fed) bank, while the entire south is covered by just two district banks. Meanwhile, as in 1913, Missouri still boasts two district banks. The Fed’s governance is distorted, too, by musty rules about Federal Open Market Committee membership and voting authority. The voting members of the FOMC are the seven board governorsalong with only five of the 12 district presidents. The president of the New York Fed is a permanent member – which makes sense, given the city’s continued status as a leading global financial centre. But at any given time, seven of the other district bank presidents cannot vote.

    Voting rotation, likewise, is rooted in historical decisions with no relevance today. Why should the presidents of the Chicago and Cleveland Fed districts act as voting members every other year, and the presidents of the other nine distinct Banks only every third year? Are the former as relevant economically and financially as decades ago?
    Another area ripe for reform is the board of governors’ pay. The six governors are each paid $179,700 a year, while the chairman receives $199,700relatively modest sums compared with the private sector.

    Unfortunately, Fed officials, like many other essential government officers, often move in and out of the private sector. But Fed employees and others in key financial positions in the US government should be banned from going into financial institutions for several years after leaving government service.
    Perhaps salary competition among central banks will improve the situation. It has been reported that Mark Carney, the new governor of the Bank of England – and a Canadian – will receive more than $1m annually.
    We still do not know if President Barack Obama will reappoint Mr Bernanke as Fed chairman for a third termnor if he would accept it. Mr Bernanke failed to perceive quickly the oncoming financial crisis; but, when he did, he acted with vigour and ingenuity. He has held QE in place despite apparent differences within the FOMC.
    To deal with the continued economic and financial circumstances, and the Fed’s outmoded structure, a new chairman would need to show similarly bold leadership quickly.

    The writer is president of Henry Kaufman & Company and author of ‘The Road to Financial Reformation’
    Copyright The Financial Times Limited 2013.