Why Aren’t US Bond Investors Panicking?

Anatole Kaletsky

People walk past the New York Stock Exchange

LONDON – As US President Donald Trump ratchets up his trade war with China and the Federal Reserve Board increases US interest rates, the prospects for the world economy and financial markets, so bright just a few months ago, appear to be darkening. Stock markets around the world have fallen back toward their February lows, business confidence has weakened in Europe and much of Asia, and policymakers worldwide are making nervous noises. Are these events the beginning of the end of the global economic expansion, or is the recent market turbulence just a false alarm?

Last month, I highlighted three indicators – the oil price, long-term US interest rates, and the dollar’s exchange rate – suggesting that global conditions would remain benign. Economists may warn that the combination of Trump’s protectionism, big tax cuts, and uncontrolled government borrowing, coming at a time when the US economy is already near full employment, will ultimately fuel inflationary pressure. But financial markets simply do not believe this message. And since the financial turbulence of early February, the message from the biggest and most important financial market – for US government bonds – has become even more reassuring.

Despite the Fed’s decision to raise short-term interest rates, and to signal more rate hikes than expected for 2019, interest rates on US ten-year bonds have fallen to levels well below their February peak. Thirty-year interest rates are now below their 2017 peak of around 3.25%. These interest-rate movements imply that bond investors are less worried today about inflation and economic overheating than they were before Trump’s tax cuts, protectionist measures, and the shift from budget consolidation to aggressive fiscal expansion.

The fact that bond investors seem unworried about inflation or overheating does not mean that Trump’s protectionism and fiscal profligacy are harmless. Financial markets are sometimes catastrophically wrong, as they were before the 2007-08 financial crisis. But the US bond market is more than just an indicator of financial opinion. The long-term interest rates set in bond markets have so much impact on business conditions that changes in investors’ views can influence economic reality almost as much as vice versa.

At present, investors’ views and economic reality are completely at odds. Long-term interest rates of around 3% come nowhere near pricing in the Fed’s inflation target of 2% plus the real economic growth of 2-3% that was likely to be achieved even before the Trump administration’s big fiscal stimulus. In fact, both economic analysis and decades of past experience suggest that long-term interest rates tend to fluctuate around the rate of nominal GDP growth. This rule of thumb implies 30-year rates in the 4-5% range. And if Trump’s efforts to boost economic growth toward 4% were taken seriously, long-term interest rates should logically rise to 6% or above.

Sooner or later, the gap between bond yields and nominal GDP growth will presumably close. Either growth will weaken dramatically, as implied by bond-market expectations, or interest rates will rise dramatically, because bond-market expectations turn out to be completely wrong.

And yet neither of these things will necessarily happen in the next year or two. GDP growth is unlikely to weaken, given the big fiscal stimulus, very high business confidence, and strong growth in personal incomes resulting from rapid job growth.

But what about bond yields? If the US economy continues growing as expected, is it not inevitable that long-term interest rates will surge to much higher levels, knocking the highly leveraged US, and ultimately the entire world economy, off its current path of strong and stable growth?

This seems unlikely, at least in the year ahead, for several related reasons. First and foremost, the belief in a “new normal” of anemic growth and low inflation is deeply embedded among investors and central bankers. After spending the decade since the financial crisis obsessing about secular stagnation and falling prices, investors and Federal Reserve officials will require many months or even years of consistent and incontrovertible evidence of inflation and higher growth to be convinced that deflationary conditions have genuinely reversed.

Even when investors accept the intellectual case for much higher bond yields, regulatory impositions on banks and pension funds, together with quantitative easing in Japan and Europe and other forms of financial repression, will ensure continuing demand for government bonds at prices far above any reasonable estimate of fundamental values.

The distorted pricing cause by regulatory pressures is amplified by a kind of conditioned response among bond investors. As inflation and interest rates have fallen steadily over the past 30 years, bond investors have been consistently rewarded for treating every temporary uptick in interest rates as a buying opportunity. This experience has created a Pavlovian reflex to “buy on dips” that can be broken only by many months or perhaps even years of negative experience. This reflex has been strongly apparent in the past two months. Whenever stock markets have fallen sharply, as they did in early February and again after Trump announced his trade sanctions on China, the bond-buying instinct became irresistible, bond prices rallied, and the resulting reductions in long-term interest rates stabilized stock markets.

At some point, the bond market’s Pavlovian behavior will stop, and long-term interest rates will move much higher. But until this happens, investors’ unshakable belief that low inflation is a permanent feature of economic reality will allow the US government to pursue increasingly inflationary policies. And the bizarrely low long-term interest rates set by complacent bond markets will provide a safety net for global financial markets – at least until complacency proves to be unsustainable. 

Anatole Kaletsky is Chief Economist and Co-Chairman of Gavekal Dragonomics. A former columnist at the Times of London, the International New York Times and the Financial Times, he is the author of Capitalism 4.0, The Birth of a New Economy, which anticipated many of the post-crisis transformations of the global economy. His 1985 book, Costs of Default, became an influential primer for Latin American and Asian governments negotiating debt defaults and restructurings with banks and the IMF.

Investors should bet on smaller nimbler companies and countries

In a time of turmoil and conflict, the best strategy is to go south and nimble

Rana Foroohar

Monopoly power is and remains a huge problem in the global economy. But the news of the last week has me wondering whether we have reached what might be called “Peak Big”: a new limit to the advantages of size.

If you think about recent news stories, from Donald Trump’s China tariffs, to the Facebook privacy scandal, to recent market volatility, the common thread is that all things large are under threat.

Big countries and regions, such as the US, China and the EU, are most at risk from a trade war. Should there be more extensive tariffs, companies with the biggest market capitalisation would most likely be hit hardest.

Manufacturing brands — Boeing, Caterpillar, 3M — have already suffered large share price dips and the Dow Jones Industrial Average, which includes the biggest stocks, fell 6 per cent on the Trump tariff news.

Meanwhile, the biggest US tech companies are squarely in the sights of regulators on both sides of the Atlantic. Even big corporate pay packages are being challenged by US rules around wage disclosures that will make the largesse of executive salaries ever more visible.

The assets that seem undervalued and safer are all smaller things. Southeast Asian “countries, as well as Southern Europe and parts of Latin America have lots of slack relative in particular to the US, but also core Europe and even China”, says Jay Pelosky, head of the investment advisory firm Pelosky Global Strategies. “They have more room for growth, profit expansion, investment, and a lot more political breathing space.”

Mr Pelosky, who is based in New York, believes regionalism is the new globalism and espouses a “tri-polar” world theory, in which the Americas, Europe and Asia go their own ways and the south of each region in particular prospers.

He has a good point. Start with the geopolitics. Much of Latin America is coming out of decades of populism and protectionism while the rest of the world seems to be plunging headlong into it.

While the US is at the end of a recovery cycle, many analysts believe Latin American markets have plenty of room to run.

The same goes in Europe, where the German DAX and the FTSE 100 are down 7 and 9 per cent since the start of the year. If you assume the EU will hold together, then you also have to assume that most of the potential growth upside is in the periphery, rather than the core (with the exception of France). Indeed, Italy’s main index is one of the few in the EU that is up for 2018. It seems that many in the market buy this story, with bond yields shrinking in countries such as Spain and Portugal.

Meanwhile, if the US and China really do end up engaging in a full-blown trade war, it may be the smaller Southeast Asian nations that will benefit, since they will continue to be open for business with both. The Association of South East Asian Nations could become an alternative supply chain and preferred trading partner for either region.

At the company level, smaller also seems smarter. Small-cap stocks are still a good buy even as the S&P 500 valuations seem high, as compared by price-to-sales ratios.

Any coming regulation in areas such as tech, will probably target big players not small and mid-sized ones. Even in China, where the largest tech firms do not have to worry about regulation in the same way, it is the big companies that investors have soured on — Chinese tech group Tencent lost $51bn off its market value last week after announcing margins would shrink to fund spending on content and technology.

It may be that Big Tech companies, like big banks, have simply become too sprawling for their own good. Smaller, more localised players will probably also avoid the worst effects of tariffs.

“In a war, it’s all about destroying symbols,” says Peter Atwater, head of the research group Financial Insyghts. “Successfully bring down the share prices of even the top 10 firms, and you’ve hurt the US financial system.”

Aside from being a less visible target for protectionism, small firms with lower debt levels are better positioned to cope with rising interest rates. Research group Strategas notes that small-cap stocks are the only asset class that has outperformed inflation in every decade from the 1930s onwards.

That may be in part because they are not overpaying their top executives like many of the largest US companies. A recent survey of US public companies by the executive compensation firm Equilar found that the median ratio of a chief executive’s pay to his or her median worker was 140 to one.

But for companies worth more than $15bn, the median ratio was 263 to one. Starting this year, the US Securities and Exchange Commission will require large US-based companies to disclose that ratio. Politicians may decide to make the most of those numbers in a midterm election year.

Of course, there are any number of events that would hurt large and small companies alike — from a global trade war to a nuclear conflict. Yet it is worth remembering that, in times of great change, chaos and conflict, it is often smaller, nimbler countries and companies that do well. This may be a time to bet on David. Goliath is overvalued.

Good Luck Trying to Beat This Market

By Mark Hulbert
Good Luck Trying to Beat This Market
Good Luck Trying to Beat This Market / Photo: Getty Images 

Stock-picking is difficult regardless of whether it’s a “stock market” or a “market of stocks.”

I’m referring to the age-old distinction between periods in which individual stocks are highly correlated with each other and times when stocks march to the beat of their own individual drummers. When they become more highly correlated—as they have been during the correction that began in late January and which continues to gather steam—analysts proclaim that it’s a monolithic “stock market” and conclude that stockpickers will have a particularly hard time beating the overall market.

In contrast, when stocks’ correlations are low, as they were for most of last year, analysts say that it’s a “market of stocks.” At such times, many assert, stock-picking has a decent chance of success.

The analysts are only half right. Index funds beat the vast majority of stockpickers in both kinds of market environments. Last year, for example, 63.1% of U.S. large-cap funds lagged the Standard & Poor’s 500 index, according to S&P Dow Jones Indices, even though 2017 supposedly was a year in which stock-picking was relatively easy.

Analysts who focus on stocks’ correlations often fail to realize that those correlations rise when the market falls, and vice versa. The only way a stockpicker could exploit that information would be if he knew in advance when the market is about to rally or decline. It’s no help to be told, after the fact, that correlations have risen or fallen.

One reason why correlations respond inversely to the market is statistical, according to Kristin Forbes, a professor of management and global economics at the Massachusetts Institute of Technology. In an email, Forbes told me that, because of the way correlation coefficients are calculated, increased volatility—which inevitably happens when the market declines—more or less automatically leads to heightened estimates of stocks’ correlations, even when nothing has really changed. The increased correlations we saw during the market’s recent correction were in part caused by this statistical idiosyncrasy.

Another reason why correlations increase when the market declines is behavioral: When fear grips investors, they tend to sell first and ask questions later. Such panic is far different than the prevailing mood during bull markets. As Jon Markman, editor of the Strategic Advantage advisory service, recently wrote, “During bull markets stocks tend to rise at a leisurely and thoughtful pace, like an 80-year-old couple out for a walk in the Florida sunshine.”

Consider stocks’ correlation with the S&P 500. As last year’s bull market took stocks to ever-higher levels, the Cboe S&P 500 Implied Correlation Index dropped to some of its lowest levels ever. But during the stock market’s correction in late January and early February, that index spiked upward.

This shouldn’t have been a surprise, once we understand the statistical and behavioral factors underlying changes in correlation. Analysts who in recent weeks have breathlessly proclaimed that we are now in a monolithic “stock market” are in fact telling us little more than that the market had declined.

What we would need to know in order to profit from this information is foreknowledge of what stocks’ correlation with the S&P 500 will be in subsequent weeks. But such foreknowledge is elusive. Periods of high or low correlation rarely persist for very long. In fact, they more often than not are quickly corrected. That means the trading environment tends to become a “market of stocks” at the very time that analysts announce it has become a “stock market”—and vice versa.

No wonder it’s so difficult to use stocks’ shifting correlations with the overall market to beat the market.

The proof of the pudding is in the eating, of course. For each year since 2007, which is when the Cboe first began calculating implied correlation indexes, I measured the proportion of the 500-plus portfolios monitored by the Hulbert Financial Digest that beat the overall market on a risk-adjusted basis. This proportion was no higher when correlations were below average than when they were above average. In all cases, furthermore, that proportion was well below 50%.

It’s not an accident that the strategies that have made the most money over the long term pay no attention to short-term or even intermediate-term changes in stocks’ correlations with the overall market. Warren Buffett, CEO of Berkshire Hathaway and widely considered to be the most successful investor alive today, advises us to “only buy something that you’d be perfectly happy to hold if the market shut down for 10 years.” If the market were to shut down, needless to say, there would be no way to even calculate stocks’ correlations with the overall market.

The bottom line? You should give up if you’re basing your stock-picking strategy on whether you think it’s a “market of stocks” or a “stock market.” The odds are overwhelming that your strategy will lag a simple index fund.

The Best Way to Protect Yourself From Out-of-Control Governments

by Nick Giambruno

You probably know it’s a bad idea to put all of your asset eggs in one investment basket. The same goes for holding all of your assets in one country. But how much thought have you put into political diversification?

With proper planning, you can greatly reduce the risk your home government presents to your financial and personal wellbeing.

International diversification frees you from absolute dependence on any one country. Achieve that freedom, and it becomes very difficult for any group of bureaucrats to control you. The results can be life-changing.

Everyone in the world should aim for political diversification. Though it’s especially critical for those who live under a government sinking hopelessly deeper into financial trouble. That means most Western governments. The US in particular.

To get started, there are four core areas to consider: your savings, your citizenship, your income, and your digital presence.

Diversify Your Savings

It’s crucial to place some of your assets beyond the easy reach of your home government. It keeps that government from trapping your money if and when it implements capital controls or outright asset seizures. Any government can do either without warning.

You can diversify your savings in several ways:

• Foreign bank accounts

• Precious metals held abroad

• Foreign real estate

Foreign real estate is especially helpful. I call it a diversification “grand slam” because it accomplishes a number of key goals at once.

Owning real estate in a foreign country moves a good chunk of your savings into a hard asset.

One that’s outside of your home government’s immediate reach. Ideally, it’s located somewhere you’d enjoy living.

Unlike digital financial assets, it's probably impossible your home country could seize your foreign real estate.

Owning foreign real estate is one of the very few ways you can legally maintain some privacy for your wealth. In that sense, foreign real estate is the new Swiss bank account.

Foreign real estate often opens up other diversification options. In many cases, owning property in a foreign country makes it easier to open a bank account in that country.

It can also put you on the road to obtaining residency in a foreign country. It can even put you on a shortened path to citizenship in some cases.

Lastly, owning foreign real estate gives you a second home, vacation hideaway, or place to retire. It’s an emergency “bolt-hole” should you need to escape trouble back home.

Diversify Your Citizenship

One way to diversify your citizenship is with a second passport.

Unfortunately, there is no route to a second passport that is simultaneously easy, fast, cheap, and legitimate. But that does not decrease the benefits of having one.

Among other things, having a second passport allows you to invest, bank, travel, live, and do business in places you wouldn’t otherwise be able to.

There’s another important reason to get a second passport.

No matter where you live, your home government can revoke your passport at any moment under any pretext it finds convenient. Your passport doesn’t actually belong to you. It belongs to the government.

Having a second passport means that you can always escape your home country without having to live like a refugee.

Diversify Your Income

Income diversification means structuring your cash flows so you’re less dependent on any one country for your income.

The goal is to create multiple sources of revenue from international investment opportunities and trends.

Bonus diversification points if you do all this through your own offshore company domiciled in a favorable jurisdiction.

Diversify Your Digital Presence

Moving your digital presence to ideal foreign jurisdictions also adds significant political diversification benefits.

This commonly includes your IP address (which often pinpoints you to a precise physical address), email account, online file storage, and the components of personal and business websites.

Plan for Bigger Government

Somehow, someway, your home government will keep squeezing your pocketbook harder and keep subjecting you to escalating, arbitrary, and burdensome regulations and restrictions.

Expect more government and less freedom all around.

The window to protect yourself closes a bit more with each passing week. The good news is you can start to diversify internationally without leaving your home country, or even your living room.

Still, it’s essential to take the necessary steps before the government slams your window of opportunity shut. If history is any guide, it won’t be open forever.

It's much better to have developed and implemented your game plan a year early than a minute late.