No Free Lunch, Part 2

By John Mauldin


Matching the stock market’s long-term average returns sounds like it should be easy, if you’re patient enough. But in fact it is remarkably difficult. In last week’s letter, Ed Easterling and I showed you why it is a longshot bet in almost every market environment. Returns over a decade or two are usually well above or well below average. Most of all, it’s fairly predictable which side of average will occur.

This has serious implications for retirees, near-retirees and accumulators. Fortunately, there’s a lot that you can do to still achieve investment success. Today Ed and I will expand on that discussion. If you missed last week’s letter, you might want to read it here first.

Ed founded Crestmont Research in 2001 to research secular stock market cycles and graphically explain everything about them. You can find a treasure trove of his fabulous charts and articles on cycles and market returns at Longtime readers know that I’m a big fan of Ed’s work and highly recommend both of his books, especially Unexpected Returns.

We left off last week writing about the power of the price/earnings ratio (P/E) on the way to describing how it not only predicts, but also drives returns. Let’s jump back in; we have a lot to cover.

By John Mauldin and Ed Easterling

The price/earnings ratio (P/E) has a multiplier effect on stock returns. Over 10–20 years, P/E can dramatically increase or decrease, resulting in a significant addition or reduction in total return. This can either help or hurt investors. In the secular bear market of the 1960s and ’70s, the decline in P/E virtually eliminated the return from earnings growth and dividend yield. In the 1980s and ‘90s, the increase in P/E more than doubled the return for many of the decade-long periods during that secular bull market.

P/E’s effect reaches beyond earnings and capital gains. It exerts significant control over dividend yield. And, as it turns out, the reinforcing result ends up being in the favor of P/E’s other effects.

The chart below shows a high correlation between P/E ratio and dividend yield. P/E is plotted on the left axis and dividend yield runs across the bottom axis. Each dot on the graph represents the combination of P/E and dividend yield for each year since 1900. The resulting pattern provides insights about the relationship across a full range of conditions. High P/E is closely associated with low dividend yields and low P/E coincides with high dividend yields.

This is one of those rare instances when correlation reflects causation. P/E is the relationship of price to earnings. Dividend yield is the relationship of dividend payments to price (D/P). Therefore, with price as the variable that both ratios have in common, we can mathematically eliminate it for comparison and recognize that P/E and dividend yield actually reflect the relationship of earnings to dividends.

Since dividends are paid from earnings, and since the share of earnings paid as dividends varies in a relatively narrow range over time, we see a close relationship between the two ratios. Valuation drives dividend yield. For example, the same dividend amount when price is based upon P/E at 20 has twice the yield when price is driven by P/E at 10.

Therefore, when a decade starts with P/E relatively low, not only is there an increased likelihood rising P/E will boost returns, but the same low starting P/E also boosts returns by driving dividend yield higher. The opposite effects occur during periods that start with relatively high P/E.

These principles of valuation, rather than random chance, are what drive stock market returns. That’s good because a principle-driven market is much more reliable and understandable than a random one.

This is in keeping with Benjamin Graham’s axiom, “In the short run the market is a voting machine. In the long run it’s a weighing machine.” And what it weighs are earnings.

As with many things in life, there is no certainty. But don’t allow perfection to be the enemy of the good. Low valuation significantly raises the odds of above-average results over the following 5–10 years. High valuation significantly raises the odds that cat food may be on your menu, unless you act to manage risk and enhance returns.

Neither instance is a certainty, but knowing the propensity helps you manage risk and invest for return.

Fairly Valued vs. Overvalued

It’s hard to know what to believe about today’s market. Some reports indicate that the market is overvalued, while others write about a fairly valued market with lots of upside. Those in the overvalued camp point to P/E currently being over 30. Market bulls present values near 20 or 16.

Looking only at actual reported earnings (without subjective adjustments and future forecasts), most reports of P/E stand near 20 and up to 30 in a few instances. The long-term historical average is around 15. P/E has declined below 10 during periods of high inflation or significant deflation and generally rises toward the mid-20s when inflation is low and stable. Therefore, P/E is currently above average, but is it fairly valued near 20 or overvalued near 30?

The next chart shows a long history of economic growth (measured with nominal gross domestic product) and earnings growth (measured with earnings per share for S&P 500 companies). We see the effects of business cycle fluctuations in EPS around a steadier economic progression in GDP. This graph visually reinforces why some analysts prefer to normalize earnings in order to moderate distortions. Averaging earnings over a period of time, typically 10 years, removes the recessions and business cycle outliers.

Some analysts and investors believe corporate earnings have recently upshifted and are unlikely to revert. They cite tax changes, trends in service industries, technology, and other causes. Yet all those factors and more have affected earnings, margins, and the economy for more than a century and none have conquered business cycle-driven reversion. Nonetheless, if we were earlier in the cycle, P/E would be near 20 and the market would be fairly valued.

Others think profit margins will again revert as they consistently did in the past. While profit margins and earnings may be surging, competitive processes will ultimately drive returns on equity back in line with debt yields plus equity risk premiums. The current elevated profits offer handsome returns and attract new competitors or predatory responses from existing competitors. Regardless, using various methods to normalize the business cycle shows us that P/E is near 30 and the market is vulnerable to correction.

Many on Wall Street continue to promote optimistic valuations. Buy-and-hold strategies sell better when the market is supposedly not expensive and when the market’s driver is randomness.

On the other hand, analysts and followers of CAPE P/E10, Crestmont’s P/E, and other normalizers disagree that this time is different. History rarely repeats but it does provide a powerful laboratory of experiences to assess plausibility. For now, the adage regarding history repeating has the upper hand over the adage that this time is different.

(The CAPE or “cyclically adjusted price to earnings” ratio is a valuation measure that uses real earnings per share (EPS) over a 10-year period to smooth out fluctuations in corporate profits that occur over the business cycle. It was popularized by Yale University professor Robert Shiller so it is also known as the Shiller P/E ratio. While John and Ed both believe the Crestmont ratio is superior, the CAPE is better known.)

Implications for Your Portfolio Today

To assess the stock market’s likely outcome over the next 10 years, our next graph combines P/E and 10-year annualized returns. The green bars represent the annualized total return from each decade-long period since 1900. The first bar is the period from 1900-1909 and the last bar is 2009-2018.

For each decade, P/E at the start of the respective period is graphed on an orange line. To show the predictive power of valuation on decade-long returns, the two series are offset by 10 years.

For example, note the trough in the 1970s, just over halfway across the series of green bars. The lowest point is the 10-year period from 1966-1975. The annualized compounded total return (i.e., capital gains plus dividends on a nominal basis) over that decade was 3.3%. The corresponding point directly above that bar is normalized P/E at the beginning of 1966, when CAPE P/E10 was slightly over 24.

The white space on the graph’s right side represents nine decades still underway. The last green bar is the period starting with 2009 and ending in 2018. The nine decades now in process have starting dates from 2010 through 2018.

Most important, each decade-in-process has already established its starting P/E level. Investments that start or continue in those years will perform based on the market’s valuation at that time. A diversified stock portfolio that starts at a low price inevitably outperforms one starting at a higher price.

As the bars fill in under the P/E line in the coming years, we can expect their height to generally decline to reflect the market’s rising valuation of the market across the nine years. This does more than demonstrate the inverse relationship between valuation and performance; it provides a forward-looking view of what to expect in the future.

Decades that start with high valuation can be expected to deliver 10-year annualized returns near historic lows. This doesn’t mean every year will be muted. To the contrary, investors should expect typical volatility and annual variability. But at such high valuations, bulls have less charge and bears more so.

This effect can be represented as skew in the potential outcomes for stock market returns and is highly relevant today. Valuation doesn’t drive short-term fluctuations, but it does affect the aggregate range of outcomes.

What to Do About It

Warren Buffett’s first rule of investing is “Never lose money.” His second rule is to never forget the first rule! His many decades of investment experience demonstrate the importance of minimizing losses. Losses have a disproportionate effect on cumulative returns compared to gains.

The next chart shows how a small loss requires a slightly larger gain to return to breakeven. Getting back where you started requires progressively higher gains as the magnitude of the loss increases.

The relationship works in both directions. A 40% loss can wipe out a 67% gain. Likewise, a 40% loss requires a 67% gain to recover. This disproportionate effect occurs because the loss occurs on the higher value.

There are many ways to manage portfolio risk and control losses. The tools include direct hedges (e.g., options), portfolio structure (e.g., diversification), and active management (e.g., dollar cost averaging, rebalancing, value investing). Some investment funds and financial advisors provide these for investors who don’t have the time or interest in actively managing their portfolios.

Within portfolio structure, investors can achieve diversification in a number of ways. It is more than simply multiple holdings. True diversification should include securities that are not correlated with each other so the portfolio’s engines work independently.

Diversification can also include holdings that are fundamentally or historically counter-correlated. These holdings are expected to zag when other holdings zig. The goal is not to find direct offsets, but rather to expect that each component will deliver more upside than downside.

Furthermore, when evaluating investments for diversification, consider the current return outlook. We’ve seen how average can be uncommon, even over long periods. Often, the likely result is well above or well below average.

For example, the benchmark return should be the likely future return, based upon current conditions. When the outlook for stock returns is low, many moderate “safer” investments can be attractive as diversifiers without significantly reducing overall portfolio return.


The Great Bull Market of the 1980s and 1990s delivered high returns but also reinforced some myths and misunderstandings. The academic theories of that period were inconsistent with the investment approaches investors used. They diverged from the historical wisdom of past investment sages like Benjamin Graham and David Dodd.

Graham and Dodd recognized that markets and related financial series fluctuate. Changes in valuation affect investment decisions and outcomes. Markowitz recognized this as well. He started his presentation of Modern Portfolio Theory by separating the need for relevant assumptions from his model for portfolio construction. Nonetheless, conventional wisdom soon oversimplified the crucial assumption-setting step.

The stock market’s long-term average return is a centerline around which the returns from almost all periods fluctuate. The profile of returns over periods of a decade or two looks like a barbell, with the likely outcomes concentrated away from the center. The profile is not a bell-shaped curve with most instances near the middle. Empirically, above- and below-average outcomes are much more common than average, as seen in this chart we shared last week.

“Average” is a convenient guess when outcomes are random. Statistically, average gets closest to the actual result when there is no order or pattern in the data. This may be why followers of stock market randomness use the century-long assumption for average stock market returns. If they pick the middle, they’re likely to have a small variance to explain. But if they predict in one direction and it ends up in another, they look like a weatherman.

Yet when outcomes are driven by principles—which makes them relatively predictable over investors’ horizons—assuming the average becomes the best way to be wrong.

Valuation drives stock market returns because of financial principles. Market valuation rises and falls in response to changes in inflation. When inflation rises, values fall to provide additional return as compensation.

Most financial assets, especially stocks, rise toward their highest relative value (and lowest expected return) when the inflation rate is low and stable. Bond prices rise as yields fall in response to declining inflation. Stocks, as perpetual securities, react especially well to low inflation. Coupons and dividends are most valuable when the inflation villain is subdued.

For now, inflation and bond yields are relatively tame. The stock market is currently somewhere between relatively high and overvalued by most measures. Either way, we think investors should assume below-average returns over the next decade or two. Even if today’s relatively high valuation is near fair value due to low inflation, fair value doesn’t produce average returns. Fair value delivers a return commensurate with starting valuation.

The outlook of low returns is not destiny; it is only a statement of current market conditions. Recognizing it helps investors manage investment portfolios to mitigate risk and enhance returns. There are many options for your investment portfolio other than investing in highly valued stocks. Ask your investment advisor about such options.

In a low-return environment, incremental enhancements that control risk and boost returns have more significant impact than in high-return environments. A small enhancement during the ‘90s might have been overlooked, while the same over the past 20 years would have had a material effect for accumulators and retirees.

Diversifying Your Trading Strategies

John Mauldin here. Long time readers know I’m a fan of diversifying your trading strategies as opposed to merely diversifying asset classes. That’s especially important when each asset class already has relatively high valuations. Starting from these high valuations, it is possible you are just diversifying your future losses.

While there are many ways to accomplish this, I have developed one alternative with which I am very pleased, given recent market volatility. You can find more information in the special report I’ve titled “Investing During the Great Reset.” Click on the link to learn more.

I think the next few years and perhaps even the next decade will be particularly challenging for the typical buy-and-hold, 60/40 portfolios. You don’t want to trust your retirement to a static model, especially going forward from today’s high valuations. I really urge you to get and read this paper.

I co-manage the portfolio with Steve Blumenthal of CMG, with whom I am also affiliated and registered.

Cleveland, New York, Austin, and Dallas

I have finally had both eye surgeries. So far, I’m very pleased with the results. The world is much brighter and clearer without looking through cloudy, colored cataracts. I have to return to Cleveland for a final checkup in early April, plus a quick one-day trip to New York to see yet another doctor about a 25-year-old hand injury which is starting to act up quite painfully. It happened in one of several skiing accidents which eventually convinced me to stay off the slopes.

Also next month I’ll make a quick trip to Austin and Dallas where I will do investor presentations for CMG. Please join us if you are in one of those cities. Click here for more information and to register. Then I return home to Puerto Rico for hopefully three straight weeks.

Shane has been on the road with me these last 10 days and what will be six plane trips. She has really made a difference in my being able to handle it all while staying productive. How did I get along without her all those years?

And with that, it’s time to hit the send button. Have a great week! Spring is finally here. The Strategic Investment Conference is sold out, so if you procrastinated but still want to attend you might want to get on the waiting list. There are always a few cancellations.

Your ready for warm weather analyst,

John Mauldin
Chairman, Mauldin Economics

Warren Buffett was too American to see through Kraft

The founder of Berkshire Hathaway put excess faith in US packaged food brands

John Gapper

Warren Buffett never bets against the US, the country where he built his fortune. “The record of American business has been extraordinary . . . We are lucky — gloriously lucky — to have that force at our back,” he wrote in his annual letter to Berkshire Hathaway shareholders on Saturday.

He should have been less patriotic about Kraft, the processed food group that makes staples such as Kraft Macaroni & Cheese and Velveeta, a bright yellow “processed cheese product”.

The merger that he engineered between Heinz and Kraft in 2015 has turned out very badly: Heinz paid too much for an indigestible bunch of ageing brands in the wrong country.

The $15.4bn impairment of Kraft Heinz assets that contributed to a plunge in its share price on Friday can be put down to various causes — cost-cutting by 3G, the private equity group that manages it, discounting by supermarkets, and changing tastes among millennials. But there is a simpler explanation: 98 per cent of Kraft’s sales before the merger were in North America.

It would be anathema to Mr Buffett to admit it. Not only has he always been a staunch believer in US enterprise and “our country’s almost unbelievable prosperity”, but he embodies 20th-century consumerism. His habitual drink is Cherry Coke (Berkshire holds a 9.4 per cent stake in Coca-Cola) and he picks up breakfast each day at a McDonald’s in Omaha, Nebraska.

Were he less parochial, he might have seen Kraft Heinz’s downfall coming. He noted on Monday how sales of the Kirkland Signature private label brand owned by Costco, the US discount warehouse club, had overtaken all of the Kraft Heinz brands put together. The old trick — advertising brands heavily and pushing them on to supermarket shelves — was failing.

In other words, what he calls the “moat” around US packaged food brands has been crossed. As he wrote in his 2007 annual letter, he has always avoided investing in “companies in industries prone to rapid and continuous change” in favour of those with “superiorities . . . that make life difficult for their competitors”. These were either low-cost providers or companies with “a powerful worldwide brand”.

The consumer moat was first crossed in Europe, where supermarkets have cultivated their own brands for longer, and discounters such as Aldi and Lidl have shown that consumers will avoid paying a premium for staples. Kirkland Signature’s annual sales of $39bn are old news in Europe, with private labels holding more than 40 per cent of the market in the UK and Germany.

When Kraft’s snack brands such as Cadbury and Oreo were demerged into Mondelez International in 2012, Kraft was left with history. The theory was that Heinz could push Kraft’s brands overseas, but there is little hunger for American concoctions such as Cheez Whiz, nor thirst for Kool-Aid, the brand of flavoured soda powders invented in Mr Buffett’s home state in 1927.

This was compounded by the cost-cutting zeal of 3G, Mr Buffett’s unlikely partner at Kraft Heinz. Mr Buffett this week defended its mantra of raising margins rather than investing in growth, saying that innovation and marketing were unaffected by zero-based budgeting. But there was collateral damage — 3G has admitted as much by putting $300m into innovation.

Decades of pursuing convenience and reliability, rather than health and organic ingredients, leave Kraft Heinz with a credibility gap when it turns to wooing the new generation. Its announcement in January that “Kraft Natural Cheese is now made with milk from cows raised without the artificial growth hormone rbST” invites the question of what “natural” meant before.

Neither as eater nor investor has Mr Buffett much appetite for millennial brands. “If you think about it, people do not change their habits that much . . . There are very few billion-dollar brands that have been created in food,” he told CNBC. He prefers the old ones, citing their bargaining power over the grocery store founded by his great-grandfather in 1869.

But every brand starts small — Ben & Jerry’s ice cream was founded in 1978 before outgrowing its craft roots and being acquired by Unilever in 2000. The most troubling development for Mr Buffett is that retailers have adapted to consumers better than Kraft Heinz. The Simple Truth organic brand created by the US supermarket chain Kroger passed $2bn in annual sales in 2017.

This has daunting implications for his attachment to US food and drink brands. Low cost retailers such as Costco and Walmart still have moats similar to the one around Geico, Berkshire Hathaway’s retail insurer. They can sell their own staples, competing with Kraft Heinz and others, and cutting the price premium they enjoyed.

It also shows that his fondness for the US reached a limit with the Kraft Heinz deal. The notion that Kraft’s quaint products could be given the 3G treatment yet manage to grow relied on the country remaining a retail world unto itself. It turns out to have more in common with Europe than he realised: advertising flavoured with history is no longer enough.


by Egon von Greyerz

Have the Ides of March been delayed in 2019? Normally the Ides of March just means the date March 15th. Shakespeare made the expression ominous as it was the day that Julius Caesar was murdered. Today in 2019, the 29th of March seems more significant than the 15th. Because on the 29th, we first have the conclusion of Brexit. Or maybe we don’t! Brexit has been a tortuous process that after 3 years has got nowhere. All it has done is to reveal the EU elite’s megalomania as well as their intransigence. It has also revealed the complete incompetence of the UK government as well as Mrs May’s total indecisiveness and her inability to distinguish between activity and achievement.


March 29th is also very important in the banking world since it is the date when gold is recognised as a Tier 1 asset and thus equal to cash. Until now, gold was only a Tier 3 asset and its value was taken at 50% for the purpose of a bank’s solvency. It is of course totally ridiculous that cash or fiat currencies which we know always go to zero over time, should have been taken at twice the value of gold.

There are people speculating that gold becoming a Tier 1 asset will have major significance for the gold price. Also, some market observers even think that this is the beginning of a new era with gold again resuming the mantle of backing currencies or SDRs (Special Drawing Rights). Obviously this would require a substantial revaluation of gold in relation to the dollar in order to achieve sufficient cover for the debt outstanding.

So shall we beware of the Ides of March as Shakespeare said and will they be delayed to March 29th in 2019? I doubt that Brexit, which is a mess that won’t end well, will be resolved by March 29. Also, the global debt situation will necessitate a restructuring of the currency system. And sadly, there are no SDRs or no new government crypto currencies that will make the debt just disappear. As the story goes: “All the king’s horses and all the kings men couldn’t put Humpty back together again.”

But even if the Ides of March are not delayed and March 29th 2019 does not have a major influence on the world, it will serve as a warning of things that are likely to happen in the world financial system. Desperate debt laden governments will take desperate decisions. We could easily see a time when the US devalues the dollar significantly or introduces a crypto dollar and backs it with gold at a massively higher price.


I doubt that the US will succeed in maintaining the hegemony of the dollar in the longer term, for a number of reasons.

Firstly, the US is unlikely to be able to prove that they have the 8,000 tonnes of gold that they purport.

Secondly, China and Russia would never accept that the debt infested USA is still in control of the world’s reserve currency. A country with 60 years of real deficits, 45 years of trade deficits and at least $200 trillion of debts and unfunded liabilities does not deserve to have the reserve currency of the world.


The next few years will give us all unlimited opportunities to lose money. Last week I talked about 3 dozen reasons to buy gold and risks to investors’ assets. At least 99.5% of investors are oblivious to the risks I outlined which is clearly surprising since they will lead to the biggest asset destruction in history.

But the norm is that maximum bullishness occurs at market peaks. The coming decline in all asset markets, be it stocks, bonds or property will shock investors, as they in real terms will lose at least 75% of their assets and probably more than 90% in most cases. The 3 dozen financial, economic, political and geopolitical risks will see to that.

The problem is that the world is now entering an era when money printing and deficit spending no longer will work. It has been an absolute miracle that the world has survived on fake money and fake promises for such a long time. But we have now reached the point where it will no longer be possible to fool all of the people all of the time.


Throughout history governments have mismanaged the economy and thus destroyed the people’s hard earned money. This is the rule rather than the exception. There are numerous examples of countries collapsing under their own debt but the best analogy to the world’s situation today is the Roman Empire because of its size. During a 500 year period, the Romans dominated an area, both militarily and culturally, which included major parts of Europe, North Africa and parts of Asia.

As with all empires, the Roman one carried the seeds of its own destruction. Interestingly the world is now at a point when virtually all countries carry these destructive seeds. After the fall of the Roman Empire, the Dark Ages lasted for over 500 years. But as opposed to the Roman Empire, the current period of debts, deficits and decay encompasses the whole world and is of a magnitude much greater than 2,000 years ago. Therefore, it is likely that the effects of the coming collapse of the world economy could last a very long time. Just as the term the “Dark Ages” was only invented in the 14th century, future historians will only know afterwards if the world is now entering a period which will be a Return to the Dark Ages.

If that will be the case, there would be a total destruction of both the financial system and the world economy with all its infrastructure. It would also involve wars, civil wars, a breakdown of society and a fall in population by several billion. To most people, this clearly sounds like unrealistic scaremongering and a prophecy of doom and gloom of dramatic proportions. The intellectual capacity of most human beings doesn’t include these complex issues and longer term projections. Much simpler to talk about Brexit or Trump and his alleged Russia connection.

Clearly we hope that these cataclysmic events will not come to pass. But what we do know is that the risk is greater than ever in history. And just like the Dark Ages, we will only know about it after the event. The older generation living today would see the mere beginning of the fall but that can be dramatic enough. What is certain is that our children and grandchildren are very unlikely to have the prosperous and peaceful life that most of the world has enjoyed since 1945.

It is virtually impossible to prepare for a potential extended downfall but what we can do is to prepare for the short term and protect our investment assets.


Governments have many tricks in their bag to steal the citizens’ money.

The easiest way is to debase the currency. And this all governments have done with superb skill throughout history. As the Roman Empire started to crumble the value of the currency, the silver Denarius, fell rapidly. In those days, money printing consisted of reducing the silver content of the coin. So from almost 90% silver in 180 AD, the rulers cheated their people by using less and less silver to coin the Denarius. By 270 AD, around 90 years later, the silver coin was both silver-less and worthless.

Gradually, the Roman Empire started to crumble and Rome had all the expected problems of a state that was living above its means including major deficits and debts.

In 180 AD Cassius wrote:

“Our history now descends from a kingdom of gold to one of iron and rust as did the affairs of the Romans that day.”

Since the beginning of the 20th century, the world has experienced exactly the same thing as the Romans did 1,800 years earlier. The value of all currencies has declined by 97% to 99% and we will see all the major currencies reaching their intrinsic value of ZERO.

In 1949 Ludwig von Mises wrote:

“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.”

Thus, history repeats itself and we are again at the point when “the final catastrophe” is very near. The chart of the Denarius almost 2,000 years ago and the statement of Cassius are almost identical to the currency chart of the 20th century and von Mises’ statement.

Plus ça change, plus c’est la même chose

The more it changes, the more it’s the same thing.

So this year we should clearly beware of the Ides of March even if they are late. But it is not enough to be aware. We must also take the necessary actions to avoid suffering from “the final catastrophe of the currency system involved.”

Physical gold is the best means to avoid that catastrophe.

Beijing Risks Choking Recovery Before It Begins

Are banks and shadow banks free to lend again? Don’t ask Beijing. 

By Nathaniel Taplin

China’s gauge of factory activity for February released Thursday fell to its weakest since early 2016 at 49.2—the third straight month of contraction. That sounds worrying, but there are some economic green shoots appearing. Unfortunately Beijing’s leadership is divided on what to do next: meaning the possibility of a policy mistake derailing growth or markets is rising.

First, the good news: new orders rebounded for the first time since May. Big, state-owned factories are starting to benefit from policy stimulus and infrastructure investment, which has been slowly recovering since late 2018.

The purchasing managers index looked much uglier for small, export-exposed private firms who are critical to employment and income growth. But there have been some hopeful signs recently there too, particularly on funding. Chinese shadow banking, which cash-starved private companies depend on, rose by a cool 343 billion yuan ($51 billion) in January—the first rise since last February. Yields on AA- rated bonds, among the best real-time indicators of small business borrowing costs, have fallen about 0.5 percentage points since late December.

Policy makers, still under pressure to take a hard line on financial risks, are deeply ambivalent about this easing of conditions. Short-term bill financing—often the only type of loans risk-averse state banks will grant small firms—was a big part of record lending numbers in January. Some in Beijing are unhappy that so much lending is short-term, because that’s helping drive new bubbles in stocks and high-rated bonds. The strong credit data prompted a rare public spat between Premier Li Keqiang and the central bank last week—the former arguing that the sharp rise in bill financing creates new potential risks, and the latter appearing to respond hours later through a question and answer in its official newspaper, saying such risks are minimal.
An employee at a textile factory in China's eastern Zhejiang province, Feb. 25.

An employee at a textile factory in China's eastern Zhejiang province, Feb. 25. Photo: str/Agence France-Presse/Getty Images 

Ambivalence toward the nascent shadow banking rebound is also obvious. On Monday, a statement on the topic by China’s bank regulator called for promoting financial intermediation by businesses who “operate cautiously in accordance with regulations.” The same statement, however, resolved to go on “blocking the side door and opening the front door,” official-lese for forcing lending back on bank balance sheets. The regulator also said “structural deleveraging has hit its expected target.” But the day after, a central bank representative called for “pushing forward structural deleveraging.”

With so many conflicting signals coming out of Beijing, local regulators and loan officers may conclude the safest route is to pull back and wait for more clarity. These green shoots are fragile. Too many gardeners stomping around Beijing isn’t helping.

Risky Retirement Business 

Regardless of whether yields in advanced economies rise, fall, or stay the same, core demographic trends are unlikely to change in the coming years, implying that pension costs will continue to balloon. Is there an asset class that can provide yield-hungry pension-fund managers what they're looking for?

Carmen M. Reinhart , Christoph Trebesch

retirees play cards

CAMBRIDGE – The challenges posed by an aging population are manifold, and they are neither new nor unique. The populations of Italy and Japan have been declining for some time, and in the United States, numerous state governments’ large unfunded pension liabilities are a chronic problema.

While low interest rates in most advanced economies have held down governments’ borrowing costs, they pose significant challenges for pension asset management. In real (inflation-adjusted) terms, returns on Japanese, German, and other European sovereign bonds have been negative for some time. Short-term interest rates on US Treasuries may have drifted higher as the Federal Reserve began to unwind its post-crisis stimulus policies (and may edge higher still after the Fed’s current pause), but longer-term US interest rates remain low by historical standards.

The two decades after World War II, as one of us has documented, were also characterized by low real returns on government bonds in both the US and elsewhere. Unlike now, however, that era boasted a much younger and faster-growing population. Furthermore, households had trivial debt levels by modern standards. The solvency of pension plans was not yet a concern.

Regardless of whether yields in advanced economies rise, fall, or stay the same, core demographic trends are unlikely to change in the coming years, implying that pension costs will continue to balloon. Since the creation of the US Social Security system in 1935, Americans’ life expectancy has risen by almost 17 years, while the retirement age has risen by less than two years. In 1946, the assets of pensions amounted to about 29% of US GDP; they have almost quadrupled since then.

Understandably, the search for higher yields has become a higher priority, even for fully-funded pension plans. When unfunded liabilities (which represent the assets that pension funds will have to purchase in the future to meet their obligations) are included, the magnitudes soar even higher.

The search for higher returns has led US pension plans (excluding that of the federal government) to tilt toward equity markets in recent years. This trend has been evident among other investors as well, including some of the world’s largest sovereign wealth funds. But our recent work with Josefin Meyer suggests that another asset class can provide real long-term returns above those of “risk-free” US government securities.

In our study, we focus on external sovereign bonds and compile a new database of 220,000 monthly prices of foreign-currency government bonds, covering 91 countries, traded in London and New York between 1815 and 2016. Our main insight is that, as in equity markets, the returns on external sovereign bonds (largely bonds issued by emerging market countries and now-advanced economies) have been sufficiently high to compensate investors for risk.

Real ex post returns on external sovereign bonds averaged 7% annually across two centuries, including default episodes, major wars, and global crises. An investor entering this market in any given year received an average excess yearly return of around 4% above US or British government bonds, which is comparable to stocks and higher than corporate bonds.

The observed returns are difficult to reconcile with the degree of credit risk in this market, as measured by historical default and recovery rates. Based on our archive of more than 300 sovereign debt restructurings since 1815, we show that cases of full repudiation of sovereign debt are relatively rare and mostly connected with major revolutions (Russia in the early twentieth century, China’s Maoist regime, Cuba, and the European countries that fell under Soviet control following World War II). For the full asset class over two centuries, the typical haircut investors suffer in debt crises is below 50% – a smaller haircut than Moody’s estimates for US corporates over the past century.

The main driver of the higher ex post real returns is the comparatively high coupon these sovereign bonds offer. Beyond the return history itself, there is the fact that emerging and developing economies now account for about two-thirds of global GDP, compared to just one-third 50 years ago, when portfolio diversification was almost entirely a domestic affair. Adding to the attractiveness of a portfolio of emerging-market sovereign securities, its returns are not perfectly correlated with equity returns. Moreover, there is evidence that creditor rights and enforcement powers in external sovereign debt markets have increased in the wake of recent US court judgements.

These findings are not an invitation to embrace indiscriminate risk taking. Another wave of sovereign defaults may be ahead of us, and sovereign bonds can become highly illiquid in distress. Nonetheless, our results highlight the long-term gains from diversification into a growing but relatively under-studied asset class. And for pensions, the risks of relying on assets that offer negative or only very low long-term real returns are no less serious, especially as they compound over time.

Carmen M. Reinhart is Professor of the International Financial System at Harvard University's Kennedy School of Government.

Christoph Trebesch is Professor of Macroeconomics at the Kiel Institute for the World Economy.

Remember, The Fed Hasn’t Actually Done Anything Yet

When the financial markets got, um, choppy towards the end of 2018, the Fed caved almost instantly.

But only rhetorically.

Fed chair Powell promised to stop raising interest rates and shrinking the money supply, and the financial markets, trained to salivate at the sound of Fed happy talk, immediately morphed from “risk-off” to “risk-on.” Stocks are now approaching last year’s all-time highs, bond prices are way up (which is to say long-term interest rates are way down) and the financial press is back to celebrating the “Goldilocks economy.”

But remember that as far as actual monetary policy goes, nothing has changed. Last year’s Fed Funds rate increases are still in place, while the Fed’s balance sheet remains diminished (which is to say the cash drained from the economy as the bonds in the Fed’s account were retired remains out of action).

So the damage has not been undone, and it’s starting to bite. Some examples:

US retail sales are falling:


Housing, which a year ago was in a mini-bubble, is rolling over. Housing starts are down…


… while existing home sales have cratered:


US manufacturing orders missed big in the most recent reporting month:

Manufacturing orders permenant QE

Corporate earnings, meanwhile, are so weak that analysts are talking about an “earnings recession”:

From a February Zero Hedge article:

One week ago, when looking at the dramatic collapse in consensus Q1 EPS estimates, we noted that the “profit party” is over and the days of near record earnings growth are about to end with a bang as a result of the recent barrage in profit warnings and negative preannouncements, first and foremost starting with Apple, which issued a shocking guidance cut one month ago for the first time since 2001. As a result, analysts have slashed their S&P500 earnings estimates for the first quarter, and the Q1 bottom-up EPS estimate dropped by 4.1% (to $38.55 from $40.21) during this period. 
All eleven sectors recorded a decline in their bottom-up EPS estimate during the first month of the quarter, led by Energy (-22.5%) and Information Technology (-7.3%).  
Overall, seven sectors recorded a larger decrease in their bottom-up EPS estimate relative to their 5-year average and their 10-year average for the first month of a quarter.

And the slowdown is global. Here’s German GDP growth:

German GDP permenant QE
In February MarketWatch asked:

Is Germany already in a ‘technical’ recession? These economists think so
Investors are worried that a global slowdown led by China could begin to sap U.S. growth, but it’s Europe that’s looking a little sickly at the momento. 
Expectations that Germany, Europe’s largest economy, could post a second consecutive quarter of falling gross domestic product were on the rise after a dismal reading on November industrial production last week, which showed a 1.9% fall, defying a forecast for a 0.3% rise. 
“Industrial production data was a proper disappointment this month. Our German GDP tracker has deteriorated to minus 0.1% [quarter-on-quarter]. This would be the second consecutive [quarter-on-quarter] GDP contraction, meaning Germany could now be in a technical recession,” wrote economists Evelyn Herrmann and Gilles Moec at Bank of American Merrill Lynch, in a Monday note (see chart below). 
Germany’s slowdown is attributable in part to slowing activity in China, the economists said. And concerns about China are certainly on the rise thanks to homegrown headwinds and the continued trade battle with the U.S.

What does all this mean? Mainly that despite the recent bounce in US financial asset prices, the Fed didn’t succeed in stabilizing the real economy. With the major countries pretty much all slowing down, corporate profits will likely fall this year. Falling corporate profits tend not so support record-high share prices. And the longer the slowdown continues the bigger the risk that stock investors will catch on and panic, taking us back to the flash bear market of late 2018.

Then it gets interesting. Realizing that words have failed, the Fed will be forced to stop promising and start delivering. So the second act of this play will be not just a pause but a reversal of last year’s tightening.

But this won’t work either. A modest reduction in interest rate cuts and slight increase in asset purchases will buy, at most, another two-month pop in share prices, followed by another realization that the economy is still weakening, followed by yet another, probably much bigger stock market plunge.

Eventually, we’ll settle into a permanent state of ever-increasing QE, zero-to-negative interest rates and every imaginable kind of fiscal stimulus.

A simple way to guage our place on this path is the price of gold. When Act Two (gradually falling interest rates, modest QE) is implemented, gold should bounce back up to around $2,000/oz. Once Act Three (massive, permanent QE, NIRP, bailouts for bankrupt states and cities) is in full swing, gold should pass $5,000 on its way to infinity.