Buttonwood

America’s disproportionate weight in global stockmarket índices

Japan dominated the index in the late 1980s. That didn’t end well
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THE aims of a stockmarket index are threefold. First, to reflect what is actually going on in the market; second, to create a benchmark against which professional fund managers can be judged; and third, to allow investors to assemble well-diversified, low-cost portfolios. On all three counts, there are reasons to worry about the MSCI All Country World Index, one of the most widely used gauges of the global stockmarket.

That is because the American market has a weighting of 54% in the index, as high as it has ever been (it reached the same level in 2002). In other words, anyone using the index to monitor the market is seeing a picture heavily distorted by Wall Street. The relative performance of international fund managers against the index will largely depend on how much exposure to America they are willing to take on. And anyone buying a tracking fund is making a big bet on the American market. Things are even worse if investors track the MSCI World Index, which covers only developed markets. In that benchmark, America’s weight is 60.5%.

There is nothing wrong with the way that MSCI calculates its indices; the weights reflect how America dominates global markets. With world index funds having fees as low as 0.3% a year, they look a tempting option. But there are worrying parallels with the way that Japan dominated the index in the late 1980s.

At its peak, the Japanese market was 44% of the MSCI index. That was far more than double the Asian economy’s share of global GDP at the time (see chart). Investors were enthusiastic about all-conquering Japanese multinationals like Toyota and Sony; the talk then was of the rest of the world needing to learn from the Japanese model. Japan’s companies were free from the threat of takeover and able to pursue long-term expansion plans without worrying about short-term profits.
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The American stockmarket’s index weight is also more than double the country’s share of global GDP. The gap has widened since the start of the millennium, because America’s share of world GDP has been on a downward trend. Today’s investors are wildly enthusiastic about America’s all-conquering technology groups, such as Google, Facebook and Amazon. They, too, are either shielded from the threat of takeover by special shareholder structures, or in the case of Amazon, have persuaded investors that long-term growth is more important than short-term profits. Other countries only wish they could create technology giants with the same reach as one of America’s titans.

Do such parallels mean that America is doomed to follow the same path as Japan, whose stockmarket weight steadily dwindled until it fell back in line with its contribution to global GDP? Not necessarily. A country’s stockmarket is less likely to be an exact replica of its domestic economy; only around a half of the profits made by S&P 500 companies are earned at home. The weight of American firms in the global index has been given an extra boost by the recent strength of the dollar.

Still, investors may grant a higher valuation to a country’s stockmarket because they perceive it to have attractive fundamentals. The American market is nothing like as highly valued as Japan’s was in the late 1980s, when sceptics were told that Western valuation methods did not work in Tokyo. Still American companies trade on a multiple of 21 times last year’s earnings, compared with 18 for Europe, 17 for Japan and 14 for emerging markets. On a cyclically adjusted basis (averaging profits over ten years), the ratio of the American market to earnings is as high as it was in the bubble periods of the late 1920s and 1990s. And it is worth remembering that those corporate profits are still very high, relative to GDP, by historical standards.

Perhaps all these things can be justified. America may have better prospects for economic growth than the rest of the developed world, not least because of its favourable demography. Its technology giants may be less vulnerable to competition than the Japanese multinationals of the late 1980s because they benefit from “network effects”, or natural monopolies. And profits may have shifted to a higher level in a world where trade unions are weak, the cost of capital is low and business is very mobile.

Nevertheless, an investment in the MSCI indices is an implicit bet on three things: the importance of the American stockmarket; the valuation placed on American companies; and the robustness of profits as a proportion of American GDP. This is not the kind of lower-risk option which those buying an index-tracker probably have in mind.


Illiberal Stagnation

Joseph E. Stiglitz

Vladimir Putin


NEW YORK – Today, a quarter-century after the Cold War’s end, the West and Russia are again at odds. This time, though, at least on one side, the dispute is more transparently about geopolitical power, not ideology. The West has supported in a variety of ways democratic movements in the post-Soviet region, hardly hiding its enthusiasm for the various “color” revolutions that have replaced long-standing dictators with more responsive leaders – though not all have turned out to be the committed democrats they pretended to be.
 
Too many countries of the former Soviet bloc remain under the control of authoritarian leaders, including some, like Russian President Vladimir Putin, who have learned how to maintain a more convincing façade of elections than their communist predecessors. They sell their system of “illiberal democracy” on the basis of pragmatism, not some universal theory of history. These leaders claim that they are simply more effective at getting things done.
 
That is certainly true when it comes to stirring nationalist sentiment and stifling dissent. They have been less effective, however, in nurturing long-term economic growth. Once one of the world’s two superpowers, Russia’s GDP is now about 40% of Germany’s and just over 50% of France’s. Life expectancy at birth ranks 153rd in the world, just behind Honduras and Kazakhstan.
 
In terms of per capita income, Russia now ranks 73rd (in terms of purchasing power parity) – well below the Soviet Union’s former satellites in Central and Eastern Europe. The country has deindustrialized: the vast majority of its exports now come from natural resources. It has not evolved into a “normal” market economy, but rather into a peculiar form of crony-state capitalism.
 
Yes, Russia still punches above its weight in some areas, like nuclear weapons. And it retains veto power at the United Nations. As the recent hacking of the Democratic Party in the United States shows, it has cyber capacities that enable it to be enormously meddlesome in Western elections.
 
There is every reason to believe that such intrusions will continue. Given US President Donald Trump’s deep ties with unsavory Russian characters (themselves closely linked to Putin), Americans are deeply concerned about potential Russian influences in the US – matters that may be clarified by ongoing investigations.
 
Many had much higher hopes for Russia, and the former Soviet Union more broadly, when the Iron Curtain fell. After seven decades of Communism, the transition to a democratic market economy would not be easy. But, given the obvious advantages of democratic market capitalism to the system that had just fallen apart, it was assumed that the economy would flourish and citizens would demand a greater voice.
 
What went wrong? Who, if anyone, is to blame? Could Russia’s post-communist transition have been managed better?
 
We can never answer such questions definitively: history cannot be re-run. But I believe what we are confronting is partly the legacy of the flawed Washington Consensus that shaped Russia’s transition.
 
This framework’s influences was reflected in the tremendous emphasis reformers placed on privatization, no matter how it was done, with speed taking precedence over everything else, including creating the institutional infrastructure needed to make a market economy work.
 
Fifteen years ago, when I wrote Globalization and its Discontents, I argued that this “shock therapy” approach to economic reform was a dismal failure. But defenders of that doctrine cautioned patience: one could make such judgments only with a longer-run perspective.
 
Today, more than a quarter-century since the onset of transition, those earlier results have been confirmed, and those who argued that private property rights, once created, would give rise to broader demands for the rule of law have been proven wrong. Russia and many of the other transition countries are lagging further behind the advanced economies than ever. GDP in some transition countries is below its level at the beginning of the transition.
 
Many in Russia believe that the US Treasury pushed Washington Consensus policies to weaken their country. The deep corruption of the Harvard University team chosen to “help” Russia in its transition, described in a detailed account published in 2006 by Institutional Investor, reinforced these beliefs.
 
I believe the explanation was less sinister: flawed ideas, even with the best of intentions, can have serious consequences. And the opportunities for self-interested greed offered by Russia were simply too great for some to resist. Clearly, democratization in Russia required efforts aimed at ensuring shared prosperity, not policies that led to the creation of an oligarchy.
 
The West’s failures then should not undermine its resolve now to work to create democratic states respecting human rights and international law. The US is struggling to prevent the Trump administration’s extremism – whether it’s a travel ban aimed at Muslims, science-denying environmental policies, or threats to ignore international trade commitments – from being normalized. But other countries’ violations of international law, such as Russia’s actions in Ukraine, cannot be “normalized” either.
 
 


Why The Fed May Need To Begin Unwinding Its Balance Sheet

by: Long/Short Investments


Summary
 
- The Federal Reserve has increased rates twice in its past three meetings.

- However, despite boosting rates from a lower-bound yield of just 0.25%, this hasn’t provided any real boost to back-end yields.

- Accordingly, with demand staying steady for higher-duration fixed-yield securities, the Fed may run into an issue with excessive flattening of the yield curve.

- I run through one way to potentially alleviate this issue.

- I consider some of the basic benefits, weaknesses, and potential ramifications of the idea, including likely effects on the financial markets.
 
Argument
 
If the US Federal Reserve begins to prioritize running off the long-dated assets on its balance sheet, this will have the effect of boosting back-end yields on the yield curve. The effect of this could be twofold:
 
(1) It helps steepen the yield curve, which is essential for the sake of bank profitability and overall health of the economy
 
(2) It will assist the Fed in finding a way to wind down its balance sheet while accomplishing its current prerogative to tighten monetary policy at the same time
 
At the same time, there are drawbacks:
 
(1) Ratcheting up back-end yields will cause some level of capital flight out of stocks as bonds become comparatively more attractive from a risk-reward standpoint. This could, at least in the short-term, remove wealth from the economy as investors move into lower-yielding assets.
 
(2) This would affect the Fed's current plans of hiking short-term interest rates over the next 1-3 years. Tightening monetary policy using the overnight rate (also known as the federal funds rate) is the most common policy approach and its effects are the most predictable.
 
Running off long-dated balance sheet assets and raising the fed funds rate simultaneously (and on its currently anticipated schedule) may tighten financial conditions too quickly.
 
In terms of financial market ramifications this would benefit:
 
(1) Any news on this would benefit the US dollar (NYSEARCA:UUP) (NYSEARCA:UDN), as more capital migrates into US markets in anticipation of higher yields.

(2) US banks and lenders (NYSEARCA:KBE) (NYSEARCA:IYG), which rely on yield curve steepening to enhance their profits.
 
(3) Those involved in the "short Treasuries" trade (NYSEARCA:TBT).
 
Overview
 
The Fed is in the midst of what is likely a somewhat short tightening cycle. I expect the Fed to boost overnight rates to somewhere in the 2.25%-3.00% range before it needs to begin cutting them again as risk builds in the system. This would be roughly half the peak of the previous tightening cycle undertaken from 2004-06, when the overnight rate hit 5.25%.
 
(Source: St. Louis Federal Reserve)
 
 
My belief is that global demand for liquid, safe securities and various domestic and global structural impediments to inflation will keep back-end yields lower. The Fed cannot raise to the point where it excessively flattens or inverts the yield curve. This strains bank profitability and precedes virtually every recession.
 
One way to alleviate this potential concern is to target back-end yields. Back in September, the Bank of Japan worked on steepening its yield curve by not only adjusting the front-end of the overnight rate, but by also pegging the 10-year yield to a point between 0-10 bps. The easiest way for the Fed to do this is not a peg, which can prove costly (i.e., not having the ability down the road to buy or sell enough assets to maintain it), but rather by unwinding a portion of its balance sheet.
 
Back on September 3, 2008, just before the fall of Lehman Brothers, the Fed's balance sheet stood at $905 billion. By December 2014, it had roughly quintupled to $4,509 billion. This is currently around 24% of GDP.
 
(Source: St. Louis Federal Reserve)
 
 
Of these assets, they are categorically split as the following:
  • 52% US Treasuries (NYSEARCA:TLT) (NYSEARCA:IEF)
  • 37% mortgage-backed securities
  • 11% reverse repo agreements
  • Sub-1% amounts of federal agency debt securities, central bank liquidity swaps, and loans
(Source: Federal Reserve)
 
 
By piling all these assets on the Fed's balance sheet, this has worked to drive up market demand for these instruments. Accordingly, prices on these have increased and yields have gone down. When these yields are no longer attractive, this has forced investors out over the risk curve into historically higher-yielding securities. Theoretically, this will help drive up economic wealth throughout the economy and produce more growth.
 
Given these are all fixed-income instruments, they have finite durations. When these securities expire, the Fed has reinvested the proceeds into new securities to keep this monetary accommodation tool in place at its current levels.
 
The Fed has already observed a 50-bp compression in the 1-month/10-year spread since it raised rates from a 0.25% lower-bound at its December meeting.
 
(Source: St. Louis Federal Reserve)
 
 
If the Fed continues to observe that raising the overnight rate is failing to provide sufficient levity to the midpoint and back-end yields as well (i.e., 5+ year yields), engineering a passive run-off with respect to longer-duration assets is one potential option.

Of its balance sheet assets, 12% have a remaining maturity of 0-90 days, 4% from 91 days to 1 year, 26% from 1 year to 5 years, 8% from 5 years to 10 years, and 50% from over 10 years.
 
Therefore, with half its balance sheet at a 10-year or greater remaining maturity and 58% at a 5-year or greater remaining maturity, passive run-off of these longer-duration assets provides one way to augment yields on the back-end without any strictly active policy approach, per se.
 
This could have the benefit of steepening the yield curve by opening up more supply of long-dated US fixed-yield securities. This would also boost lenders profits, who control the flow of credit in the economy.
 
However, if the Fed tightens too quickly, this can create a host of issues such as:
 
(1) An excessive hike in corporate capital costs, which could undermine business confidence, and result in wider corporate bond yields and higher fixed-income yields generally.
 
(2) An overly strong US dollar. After the dollar passes a certain level of strength, the marginal benefit to consumption may not outweigh the marginal hit to exporters, and produce a drag on growth.
 
(3) Pressure on equity valuations, which could in turn wipe out a material level of wealth from the economy. As yields rise, returns expectations with respect to stocks will increase in conjunction.
 
Without improvements in business fundamentals (or the expectations of such), equity values could decrease.
 
What it would mean for financial markets
 
(1) As mentioned, any tightening measure generally is bullish for the US dollar with other central banks in developed markets - ECB, BOJ, SNB, BOE - in accommodation mode.
 
(2) "Long US banks," another popular trade up there with "short Treasuries" and "long the USD," would benefit as it would allow these institutions to fulfill their fundamental role of borrowing on the short-end (still relatively cheaply) and lending more expensively on the long-end. With respect to the remainder of the equities market - and risk assets more generally - the effect is less clear.

(3) "Short treasuries" benefits. I've written before that I believe it's more attractive to short the front end of the yield curve rather than the back-end. Demand for safe, liquid securities remains high and there are various domestic and foreign structural obstacles to rising inflation going ahead. I believe that core inflation will remain in the 1.7%-2.0% range to end the year.
 
Conclusion
 
Unwinding the balance sheet isn't necessarily a priority for the Fed, but if the back end of the curve isn't showing adequate sensitivity to increases in the overnight rate (as is the case based on the last two hikes), it provides a tool by which it can use for this purpose.
 
If the Fed hikes twice more and finds that back-end yields are holding fairly steady (as I expect them to) and it's merely flattening out the curve rather than pushing it upward in mostly parallel fashion, it may need to rethink its approach. Running off the longer-duration securities can provide some level of buoyancy to back-end yields to allow the curve to remain upward-slanting. Flattening or inverting the curve saps bank profitability and is usually an indication that the current business cycle is running on its last fumes.
 
The weaknesses of this proposal include the lack of clarity in how markets would react. It would also interfere with the Fed's current tightening plans (using the well-trodden path of adjusting the overnight rate) given it would add another layer of tightening. It may excessively strengthen the dollar, which can produce a drag on growth should it too significantly impair the export sector.
 
Capital costs would also rise across the spectrum, which expands discount rates at which cash flows are valued and can compress valuations without a concomitant rise in earnings or expected improvement in business fundamentals beyond what is already priced in. This would pressure risk asset valuations as liquidity is removed from the system and increase risk more broadly.
 
Potential winners in the financial markets would include those involved in probably the three most crowded trades in the market today:

1. Long USD
 
2. Long Banks
 
3. Short US Treasuries
 
The Fed is likely several months off from needing to know whether or not it needs to act on unwinding its balance sheet. It also needs to understand how its current strategy is working and whether the economy is sufficiently healthy to make such a move, such as meeting real growth and inflation targets roughly at least 2% apiece.
 
Letting long-duration securities run off the balance sheet will give the Fed a "curve steepening" tool as well as a means by which it can more effectively use the balance sheet in the future to stimulate the economy in the future. Central banks such as the ECB and BOJ have run into issues of running out of bonds to buy to sufficiently stimulate their own economies - and perhaps call into question the efficacy of quantitative easing itself. By carefully removing some of this liquidity from the system, the Fed can effectively provide more "ammo" for itself when it needs to use monetary policy tools in the future to kickstart the economy from its end.


The Fake Recovery May Be Ending

  

charts


The “real”  Atlanta Fed’s reading of Q1 GDP   went off a cliff to less than 1%:

No one has the slightest idea of what is happening as insane levels of debt distort the model’s which economists use to forecast the future economic trends. From here on out, there will be unpleasant surprises all the way around. According to shadow stats, the GDP is in contraction at the rate of -2%.

april1


The New Normal & Disconnect:

The FED and other agencies have taken on new responsibilities for managing systemic risk since the financial crisis of 2007.

What grade have they earned?  The impact of implemented low-interest rates for savers has made them poorer. All pension plans, college endowments, and state retirement plans have been diminished and devastated by low-interest rates. Savers have suffered and will continue to do so because of ‘financial repression’.

Furthermore, because low-interest rates make savers poorer, the contracting economy has limped along with anemic growth rates. Low-interest rates have had a negative impact for almost everyone.

Preparing For The Big Crunch!

The FED will respond with even more aggressive money printing — which will then cause the entire monetary system to implode some day.  Money is not wealth, but rather it is merely a claim on wealth.  Debt is a claim on future money.  The only way to have faith in our current monetary policies is if one believes that we can grow our economy and GDP out of this massive debt that we have created.  The U.S. is already insolvent, meaning liabilities exceed assets.  The U.S. has been spending, far beyond its’ means, for multiple decades while amassing tremendous amounts of public debt, private debt and entitlement liabilities.
 
The Austrian economist Ludwig von Mises said, “There is no means of avoiding the final collapse of a boom brought about by credit expansion. The alternative is only whether the crisis should come sooner as the result of voluntary abandonment of further credit expansion, or later as a final and total catastrophe of the currency system involved.”
 
U.S. economic growth began slowing down due to its’ acceleration of ‘too much debt’. Instead of allowing natural market forces to clear out the excessive debts, the Federal Reserve chose to go into overdrive to ‘remedy’ the problem. Its’ remedy? Drive interest rates to 0% to reduce the service burden of those debts and print trillions of fresh dollars which, in turn, would fund new borrowing.

Of course, no true ‘solution’ for resolving debt involves piling up even more of it.  The only path that history has shown that works involves fiscal austerity and reducing debt. The only real solution is “a voluntary abandonment of the credit expansion”.  

The only possible solution for recovery, today, is if the economy suddenly returns to an extremely rapid economic growth over an extended period of time.  If during such a period of rapid growth does occur, we must use that windfall to pay down the outstanding debts!  The intent of the FED treading into the never-before-tried ZIRP and NIRP waters was to ignite more borrowing, not more spending!

Pension plans have been ultimately decimated by these monetary policies!

Pension funds across the U.S. are desperate to overcome low interest rates and return to the time when future retirees were entitled to and could receive their full benefits. Pension funds which so many depend upon for their retirement security will lose trillions of dollars which will result in the depletion of receiving their benefits!
 
The chart below reflects the last two times that industrial and commercial loan contracts crashed which were in 1999 and 2007!{25 year chart} of all American Bank Commercial and Industrial Loans.The last 2 times loans contracted and broke down was 1999 & 2007

April2


A global strategy is the way to defeat Isis 2.0
    
After losses in Iraq and Syria, the terror group will turn into a virtual caliphate
     
by: Karin von Hippel
   

 

    
With Isis on the back foot in Mosul in Iraq and Raqqa in Syria, it is only a matter of time until the terrorist group loses its so-called caliphate.

While its appeal to foreign recruits was partly based on controlling territory, it would be naive to think that military defeat means the group is vanquished. In anticipation of the end game in Iraq and Syria, governments need to do all they can to eliminate Isis before version 2.0 mutates into something even more virulent — essentially a virtual caliphate.

In fact, that mutation is under way. In the nearly three years since Abu Bakr al-Baghdadi, the Isis leader, proclaimed the so-called caliphate in Mosul, the organisation has dedicated significant energy to attacks outside Iraq and Syria and hundreds of its victims have been killed in places far from the Middle East.

The attack in London last month was only the most recent: in Europe and North America, 330 civilians have been killed in more than 20 Isis-inspired or -directed attacks, and hundreds more injured. In Turkey, more than 300 civilians have been killed.

For some time, experts had been predicting that increased military pressure on Isis’s core in Iraq and Syria — driven by a handful of countries in the 68-member, US-led global coalition — would cause the terrorist group to lash out on the periphery, in order to demonstrate its staying power.

Such attacks ensure a flow of fresh recruits by promoting an image of the group’s invincibility: the international community is pounding Isis and yet it is still able to cause significant harm elsewhere. As the group loses its territorial grip, we can expect more attacks unless greater efforts are made to prevent them.

While significant gains have been made by the coalition, in partnership with local forces, not just in Iraq and Syria but also in Libya, overall it has not been able to halt the violent ideology as it metastasises across the world. The coalition was, in any case, designed to defeat Isis in Iraq and Syria, and not tackle out-of-area challenges.

In response to recent attacks, a number of countries have been reviewing and upgrading their domestic counterterrorism capacities to deal with recent attacks, often learning from experiences elsewhere.

Donald Trump, the US president, promised a plan to defeat Isis. No such plan was released at the coalition meeting in Washington last month, while it appears the short-term strategy of James Mattis, US defence secretary, is to increase troop numbers in Syria and Iraq.

That will accelerate the defeat of Isis in these two countries, but will not stop attacks elsewhere. For that, more proactive global leadership is needed — whether led by the US, the coalition or some smaller association of countries, such as the UK, with expertise in integrating counterterrorism capabilities.

The good news is that the strength of Isis globally is not as significant as the group would like to portray, either through directing and inspiring external attacks or through its network of affiliates, which include Boko Haram in Nigeria as well as groups in Southeast Asia, north Africa and elsewhere.

Isis 2.0 may well evolve into a loose affiliation of groups, with pockets of territory in a few weak states, and a virtual leadership that controls adherents through social media and encrypted technologies. Isis is not yet capable of carrying out a synchronised, global attack involving both core and affiliate groups. It should never be allowed to develop that competence.

President Trump’s pledge to “eradicate this evil from the face of the earth” is unlikely to be realised. Ideologies are difficult to defeat, especially under the current coalition strategy, which is not focused enough on stopping out-of-area attacks and disrupting Isis 2.0. A more concerted, cross-border strategy could reduce the threat posed by Isis and its likely successor. Given the scale of global attacks and the potential for more, it is time to be more ambitious.


The writer is director-general of the Royal United Services Institute, a defence and security think-tank