Wrong numbers

Why government-bond yields have been falling again

Economic optimism and soaring stockmarkets had been expected to push them higher

EVERY year it seems that analysts and investors play a ritual game. They begin by asserting that government bonds are terrible value and that, accordingly, this must be the year when yields will rise (and prices fall). And then they get mugged by reality.

The same pattern seems to be playing out in 2017. Back in December, a poll of fund managers by Bank of America Merrill Lynch (BAML) found that pessimists on global bonds outnumbered optimists by 58 percentage points. Investors believed in a “reflation trade”, with tax cuts from Donald Trump’s administration leading to faster American growth, to which the Federal Reserve would respond with higher interest rates.
For a while, such forecasts seemed to be on the money. The yield on the ten-year Treasury bond picked up to 2.63% by March 13th (see chart). But since then the trend has changed. The Treasury-bond yield recorded a low for the year of 2.13% on June 6th. In Britain the yield on the ten-year gilt dipped below 1% on June 6th and 7th; in real terms (ie, after inflation), the yield is negative. Swiss ten-year bonds still offer a negative yield: investors will lose money if they hold them until maturity.

According to BAML, by the end of May more money had flowed into global bond funds ($168bn) this year than into equity funds ($141bn).
All this is slightly at odds with the optimism that has helped push stockmarkets to repeated highs. Closing prices for the S&P 500 and NASDAQ Composite reached new peaks on June 2nd, even as the bond yield was dropping. The MSCI World Index, an equity benchmark, has risen by 10% so far this year. Global stockmarkets have been recovering since February 2016 on hopes of faster economic growth. That would usually be a signal for bond yields to rise, not fall.

Although analysts are revising their global growth forecasts upwards, there is little sign yet of any rebound in inflation. In America the core inflation rate for personal consumption expenditure, a figure watched closely by the Fed, declined to 1.5% in April. Inflation rates in China, Japan and the euro zone are all under 2%. It is inflation that saps the appeal of fixed-interest investments like bonds.

In the absence of inflation, the Fed has less reason to keep increasing interest rates. Kit Juckes of Société Générale (SG), a French bank, says the market is pricing in short-term interest rates of only 1.7% in two years’ time. “Investors are losing faith in the idea that the Fed will push rates up to 2.5% or above,” he says.

Another reason why bond yields have retreated is that the fiscal stimulus promised by Mr Trump seems likely be delayed. The proposed infrastructure programme (actually tax credits for investors) is a long way from fruition. And the administration’s budget proposal includes cuts to popular programmes such as Medicaid that will struggle to get through Congress. Since the stimulus was expected to push up the budget deficit (and require the issuing of more bonds), any delay is good news for bond yields.

More broadly, investors have also started to worry again about a potential slowdown in the Chinese economy, amid signs that the authorities are tightening monetary policy. Commodity prices, seen as an indicator of Chinese demand, are at a 12-month low.

If these worries are real, why is the stockmarket doing so well? One reason is the strength of corporate profits. According to Factset, annual profits growth in the first quarter for companies in the S&P 500 index was around 14%. Part of this is the result of a rebound in energy companies’ earnings, after a slump in the oil price dropped out of the annual comparisons. But global profits forecasts for 2017 are still being revised higher.

Companies are benefiting because there is little sign of wage pressure. Even though the American unemployment rate dropped to 4.3% in May, year-on-year growth in average earnings in America was just 2.5%. “Labour is in demand because it is cheap,” say analysts at Rabobank. In turn, subdued wage growth means there is little upward pressure on inflation—good news for bonds.

This helps to explain why investors keep getting caught out in their expectations for the bond market.

In a normal economic cycle, bond yields would be heading a lot higher by now. But it has been pretty clear since 2008 that these are not normal economic times. Perhaps investors should have reflected on the example of Japan, where bond yields have stayed low for two decades despite the ups and downs of the cycle.

Labor Markets in the Age of Automation

Laura Tyson
. factory

BERKELEY – Advances in artificial intelligence and robotics are powering a new wave of automation, with machines matching or outperforming humans in a fast-growing range of tasks, including some that require complex cognitive capabilities and advanced degrees. This process has outpaced the expectations of experts; not surprisingly, its possible adverse effects on both the quantity and quality of employment have raised serious concerns.

To listen to President Donald Trump’s administration, one might think that trade remains the primary reason for the loss of manufacturing jobs in the United States. Trump’s treasury secretary, Steven Mnuchin, has declared that the possible technological displacement of workers is “not even on [the administration’s] radar screen.”

Among economists, however, the consensus is that about 80% of the loss in US manufacturing jobs over the last three decades was a result of labor-saving and productivity-enhancing technological change, with trade coming a distant second. The question, then, is whether we are headed toward a jobless future, in which technology leaves many unemployed, or a “good-jobless future,” in which a growing number of workers can no longer earn a middle-class income, regardless of their education and skills.

The answer may be some of both. The most recent major study on the topic found that, from 1990 to 2007, the penetration of industrial robots – defined as autonomous, automatically controlled, reprogrammable, and multipurpose machines – undermined both employment and wages.

Based on the study’s simulations, robots probably cost about 400,000 US jobs each year, many of them middle-income manufacturing jobs, especially in industries like automobiles, plastics, and pharmaceuticals. Of course, as a recent Economic Policy Institute report points out, these are not large numbers, relative to the overall size of the US labor market. But local job losses have had an impact: many of the most affected communities were in the Midwestern and southern states that voted for Trump, largely because of his protectionist, anti-trade promises.

As automation substitutes for labor in a growing number of occupations, the impact on the quantity and quality of jobs will intensify. And, as a recent McKinsey Global Institute study shows, there is plenty more room for such substitution. The study, which encompassed 46 countries and 80% of the global labor force, found that relatively few occupations – less than 5% – could be fully automated. But some 60% of all occupations could have at least 30% of their constitutive tasks or activities automated, based on current demonstrated technologies.

The activities most susceptible to automation in the near term are routine cognitive tasks like data collection and data processing, as well as routine manual and physical activities in structured, predictable environments. Such activities now account for 51% of US wages, and are most prevalent in sectors that employ large numbers of workers, including hotel and food services, manufacturing, and retail trade.

The McKinsey report also found a negative correlation between tasks’ wages and required skill levels on the one hand, and the potential for their automation on the other. On balance, automation reduces demand for low- and middle-skill labor in lower-paying routine tasks, while increasing demand for high-skill, high-earning labor performing abstract tasks that require technical and problem-solving skills. Simply put, technological change is skill-biased.

Over the last 30 years or so, skill-biased technological change has fueled the polarization of both employment and wages, with median workers facing real wage stagnation and non-college-educated workers suffering a significant decline in their real earnings. Such polarization fuels rising inequality in the distribution of labor income, which in turn drives growth in overall income inequality – a dynamic that many economists, from David Autor to Thomas Piketty, have emphasized.

As Michael Spence and I argue in a recent paper, skill-biased and labor-displacing intelligent machines and automation drive income inequality in several other ways, including winner-take-all effects that bring massive benefits to superstars and the luckiest few, as well as rents from imperfect competition and first-mover advantages in networked systems. Returns to digital capital tend to exceed the returns to physical capital and reflect power-law distributions, with an outsize share of returns again accruing to relatively few actors.

Technological change, Spence and I point out, has also had another inequality-enhancing consequence: it has “turbo-charged” globalization by enabling companies to source, monitor, and coordinate production processes at far-flung locations quickly and cheaply, in order to take advantage of lower labor costs. Given this, it is difficult to distinguish between the effects of technology and the effects of globalization on employment, wages, and income inequality in developed countries.

Our analysis concludes that the two forces reinforce each other, and have helped to fuel the rise in capital’s share of national income – a key variable in Piketty’s theory of wealth inequality.
The April 2017 IMF World Economic Outlook reaches a similar conclusion, attributing about 50% of the 30-year decline in labor’s share of national income in the developed economies to the impact of technology. Globalization, the IMF estimates, contributed about half that much to the decline.

Mounting anxiety about the potential effects of increasingly intelligent tools on employment, wages, and income inequality has led to calls for policies to slow the pace of automation, such as a tax on robots. Such policies, however, would undermine innovation and productivity growth, the primary force behind rising living standards.

Rather than cage the golden goose of technological progress, policymakers should focus on measures that help those who are displaced, such as education and training programs, and income support and social safety nets, including wage insurance, lifetime retraining loans, and portable health and pension benefits. More progressive tax and transfer policies will also be needed, in order to ensure that the income and wealth gains from automation are more equitably shared.

Three years ago, I argued that whether the benefits of smart machines are distributed broadly will depend not on their design, but on the design of the policies surrounding them. Since then, I have not been alone. Unfortunately, Trump’s team hasn’t gotten the message.

Amazon’s Margin-Crusher Invades the Grocery Store

Amazon.com’s purchase of Whole Foods is a targeted bet on the part of the grocery business in which it has the best prospects and is awful news for competitors such as Kroger and Wal-Mart and others

By Justin Lahart and Spencer Jakab

Amazon.com ’s AMZN +2.99%▲ purchase of Whole Foods WFM +27.26%▲ is a rounding error for the giant online retailer. For the struggling grocery industry, it is the biggest shift in a century.

Amazon.com already sells groceries, of course, along with nearly everything else, but skeptics have pointed out that supermarkets are one business that may be largely safe from its mushrooming retail empire. Today’s deal may prove the skeptics wrong.

Whole Foods will give Amazon a much bigger footprint in the food business. In addition to over 460 stores, Amazon also will be getting the high-end grocer’s distribution chain. That will allow its food delivery service, which is so far limited to only a handful of cities, to rapidly enter multiple markets.

Moreover, Whole Foods is concentrated in the richer, higher-density markets where delivery makes the most sense. A quick glance at its store locations shows this. It has 28 stores in health-conscious Colorado and Connecticut combined. Kentucky and Alabama, with an almost identical population but lower incomes, education levels and population density, have six stores combined, one each in their major urban centers.

That could give it a leg-up on other food-delivery ventures such as Royal Ahold Delhaize’s Peapod and venture-backed Blue Apron Holdings. The cache of the Whole Foods name—it was named most-admired food and drugstore by Fortune last year—could also make it a formidable competitor in the delivery business.

Whole Foods also operates at much higher profit margins than other grocers, thanks in part to the higher markups it gets for many of its upscale items. It has a gross profit margin of 34%, which compares to 21% for Kroger Co. If Amazon’s tolerance for lower profit margins in its retail business translates into its grocery venture, it could rapidly compress profitability in the sector.

Amazon’s timing for the deal appears impeccable. Its $42 a share offer represents a modest 27% premium to Whole Foods’s closing price on Thursday and just 18% to its closing price a day earlier. The entire grocery sector had sold off in the wake of a plunge in Kroger shares following a profit warning.

Even with the deal premium, Amazon’s $13.7 billion price tag including debt compares to a debt-adjusted market value of $23 billion for Whole Foods less than four years ago when it had a fifth fewer stores.

Whole Foods also operates at much higher profit margins than other grocers. Photo: Joe Raedle/Getty Images

And, while it seems somewhat surprising that Amazon is paying cash rather than some combination of shares and cash despite having one of the best-performing large-company stocks in recent years, it is more likely to make the deal accretive to earnings per share. The price represents less than 3% of Amazon’s own market value. Indeed, the rebound in Amazon’s stock price as it began trading shortly after the news broke added as much market value as the purchase price.

Rounding error or not, this is Amazon’s biggest acquisition ever and it will be consequential for the grocery industry. Amazon’s entry into a new business is awful news for anyone currently in it, and initial investor reactions show that this should be no exception.

Consider Kroger’s share price. Following its swoon on Thursday, the largest this century, its stock was off by an additional 15% in early trading on Friday in response to its formidable new competitor. And Wal-Mart , the world’s largest retailer by sales, America’s largest seller of food and Amazon’s most credible old-line competitor, saw its market value drop by $14 billion.

The Amazon-effect has finally hit the grocery business and it has been with a bang.

Beijing Lands in Another Debt Mess

Chinese authorities give provincial governments the green light to issue new land-revenue bonds

By Anjani Trivedi

The debt Beijing is ostensibly trying to rinse away through deleveraging is being reconstituted in a new form.

Take its handling of local-government debt—the largest portion of government debt overall.

Beijing this month gave provincial governments the green light to issue new land-revenue bonds. They can sell the bonds to fund infrastructure projects and use revenue from land sales, a major source of local-government income, to pay the interest.

This might seem a straightforward and legitimate way to finance local-government investment.

Alas, there’s a wrinkle: Rules issued last month bar local governments from pledging revenue from land sales for debt payments. They’re also barred from using land assets to guarantee debt issued in the past by off-balance-sheet financing vehicles linked to local governments.

The conflicting messages call into question Beijing’s commitment to lowering China’s worrying debt levels, and underline its dilemma. Infrastructure spending remains key to meeting official economic targets—investment still contributes over 40% of annual growth—and that requires an unfettered flow of financing. This flip-flop is just the latest in a series going back years, as the desire to tackle long-term financial-system risks is trumped by the need to keep near-term growth at a politically acceptable level.

Tying debt payments to the bubbling property market is a convenient stopgap. Local governments should have little trouble for now in servicing their land-revenue bonds. Of course, if property prices falter, local governments will need to find new ways of raising money—likely only perpetuating the cycle of debt creation.

Curve Inversion and Chaos to Begin by December 2017

By: Michael Pento

The bounce in Treasury yields witnessed after the election of Donald Trump is now decaying in the D.C. swamp. If the Fed continues to ignore this slow growth and deflationary signal from the bond market and continues along its current rate hiking path, the yield curve will invert by the end of this year and an equity market plunge and a recession is sure to follow.

An inverted yield curve, which has correctly predicted the last seven recessions going back to the late 1960's, occurs when short-term interest rates yield more than longer-term rates. Why is an inverted yield curve so crucial in determining the direction of markets and the economy?

Because when bank assets (longer-duration loans) generate less income than bank liabilities (short-term deposits), the incentive to make new loans dries up along with the money supply.

And when asset bubbles are starved of that monetary fuel they burst. The severity of the recession depends on the intensity of the asset bubbles in existence prior to the inversion.

The Federal Reserve has traditionally controlled overnight lending rates between banks. That all changed when the Fed started to buy longer-term Treasuries and Mortgage Backed Securities as a result of the Great Recession. Nevertheless, outside of these QE programs, the long end of the yield curve is primarily influenced by the inflationary expectations of investors. The yield curve inverts when central banks believe inflation is headed higher; but bond investors are convinced of the opposite.

The last two times the yield curve inverted was in the years 2000 and 2006. The inversion and subsequent recession that began in the year 2000 caused NASDAQ stocks to plummet 80%. The next inversion engendered the Great Recession in which the S&P 500 dropped 50% and, according to the Case/Shiller 20-City Composite Index, home prices fell over 30%.

This next inversion will occur in the context of record high equity, real estate and bond market valuations that will require another government bailout. However, this time around the recession will commence with the balance sheets of the Fed and Treasury extremely overleveraged right from the start.

As you can see from the chart below, if the 10-year Note yield (orange line) continues to fall along its current trajectory; and the Fed plods along with its avowed Dot Plot hiking path (blue line), the yield curve should invert around the end of 2017. Market chaos and another brutal recession should soon follow.

 10-Year US Treasury Yeld Measured against Fed Funds Rate

What could prevent this baneful scenario from happing?

One of the most popular Wall Street myths is that long-term interest rates rise simply because the Fed is raising the Fed Funds Rate (F.F.R.). This normally occurs because the central bank is trying to catch up to rising inflation and is initially behind the curve. However, later on in the tightening cycle long rates begin to decline as inflation is stamped out of the economy.

For example,from June 2004 thru June 2006 the Fed raised the F.F.R. from 1%-5.25%; but the 10-year note only increased from 4.7%-5.2%. That means the Benchmark Note went up just 50 bps even though the F.F.R. was raised by 425 bps. What is especially notable here is that GDP growth was well above 3% in both 2005 and 2006; as opposed to today's environment of 1.6% GDP growth for all of 2016, and just 1.2% in Q1 2017. The fear of recession and deflation is the primary reason why the 10-year Note yield is currently falling.

The Fed has been tightening monetary policy since it started to taper its $80 billion per month QE program back in December 2013. It has subsequently raised rates three times and is now most likely already ahead of the curve due to the anemic state of the economy. But, as always, the Fed fails to read the correct economic indicators and is now fixated on the low unemployment rate and its dubious effect on inflation.

Some argue that the yield curve won't invert if economic growth stalls because the Fed will then truncate its rate hike path. And indeed there is a lot of evidence for the Q2 recovery narrative to be proven false. For instance, April data on existing home contract closings declined 2.3% m/m, to a 5.57 million annual rate vs. a forecast of 5.65 million. And new homes weren't much better as single family home sales declined 11.4% to 569,000 annualized vs. the 610,000 forecast. Pending home sales also disappointed falling 1.3%. Then we had Durable Goods falling 0.7%, and Core Capital Goods orders showed no growth at all.

These data points highlight the reality that Q2 will not spring higher from the anemic Q1 growth rate. But the problem is that the F.F.R. is already close to 1%. Therefore, even if we get just two more hikes before the Fed realizes growth is faltering, that rate will be near 1.5%. In the economy slows enough that even the Fed takes notice, the 10-year Note yield should retreat back to where it was in July of 2015 (1.35%). In this second scenario, the yield curve inverts despite the Fed's failure to consummate its Dot Plot plan.

Of course, there is a small chance that the yield curve doesn't invert due to an aggressive reverse QE program--a very quick unwinding of the Fed's $4.5 trillion balance sheet. While this may avoid an inversion of the yield curve, it would also siphon off capital from the private sector, as investors divert yet more money to the Treasury. An aggressive selling of the Fed's balance sheet is a very unlikely scenario given the minutes of the May FOMC meeting. In that meeting the Fed decided to merely taper the re-investment of its balance sheet, which is the pace in that it stops reinvesting its assets. With a total debt to GDP ratio of 350%, this third scenario has very low odds of occurring; but should remand the economy into a recession even if such a plan is deployed.

Therefore, the only rational way to avoid an inverted yield curve, market chaos and a recession is if long-term Treasury yields reverse their long-term trend lower due to a rapid increase in GDP growth.

This would only occur if Trump's agenda of repatriation of foreign earnings, tax cuts and infrastructure spending is imminently adopted. But the probability of this happening very soon is getting lower by the day.

An inverted yield curve will lead to market disorder as it did in 2000 and 2006. But this next recession starts with our National debt over $20 trillion dollars and the Feds Balance Sheet at $4.5 trillion. Therefore, when the yield curve inverts for the third time this century you can expect unprecedented chaos in markets and the economy to follow shortly after. This is because the yield curve will not only invert at a much lower starting point than at any other time in history, but also with the Fed and Treasury's balance sheets already severely impaired.

There will be unprecedented volatility between inflation and deflation cycles in the future due to these factors. This represents a huge opportunity for those that can identify these inflexions points and know where to invest. To be just a bit more specific, sell your long positions now and get short once the curve inverts; and then get prepared to hedge against intractable inflation when the Fed responds to this next collapse with helicopter money.