Q3 2019 Z.1 Flow of Funds: Repo Madness

Doug Nolan

Q3 was yet another fascinating quarter for U.S. finance.

Total Credit (Non-Financial, Financial and Foreign U.S. borrowings) jumped a nominal $1.075 TN, the strongest quarterly gain since Q4 2007’s $1.159 TN, ending September at $74.862 TN (348% of GDP).

Total Credit was up $3.230 TN over the past four quarter (4.5%) and $6.446 TN (9.4%) in two years.

Non-Financial Debt (NFD) surged $835 billion during the quarter – double Q2’s growth and the strongest expansion since Q1 2004’s (aberrational) $1.234 TN.

At $53.896 TN, NFD ended September at a record 250% of GDP, up from previous cycle peaks of 226% at year-end ‘07 and 183% to end 1999.

On a percentage basis, NFD expanded at a 6.32% rate, up from Q2’s 3.15% and Q3 2018’s 4.13%.

Our federal government continues to command the debt bullet train, expanding borrowings at a 10.4% pace during the quarter (strongest since Q1 ’18).

Treasury Securities surged a notable $757 billion during the quarter to a record $18.572 TN.

Treasury Securities jumped $1.154 TN over the past year and $2.341 TN over two years.

Treasury Securities-to-GDP increased to 86%, up from Q4 07’s 41%. A broader measure of Treasury Liabilities ended Q3 at $21.048 TN, or 98% of GDP.

Bank (“Private Depository Institutions”) Assets expanded $245 billion during the quarter, or 5.0% annualized, to $19.753 TN.

One-year growth was $829 billion, or 4.4%.

Loans increased $118 billion (to $11.580 TN), or 4.1% annualized.

Mortgage Loans increased $57 billion, or 4.1% annualized, to $5.597 TN (Total Mortgage Lending increased $185 billion, the strongest quarterly gain since Q4 ’07).

While the bank lending business was rather humdrum, the capital markets side of things was anything but.

Bank Debt Securities holdings were up $141 billion, or 12.5% annualized, during Q3 to a record $4.639 TN.

Treasuries gained $84 billion ($205bn y-o-y) and Agency/MBS $54 billion ($265bn y-o-y).

Total Debt Securities holdings jumped $464 billion, or 11.1%, over four quarters.

Bank “repo” Assets declined $23 billion during the quarter to $736 billion, though one-year growth of $193 billion was up 36%.

And while on the subject of booming capital markets, Broker/Dealer Assets jumped $102 billion, or 12% annualized, during Q3 to $3.588 TN (high since Q1 ’13).

Over the past year, Broker/Dealer assets surged $394 billion, the strongest one-year growth since 2007.

For the quarter, Debt Securities holdings were unchanged at $450 billion, with Treasuries declining $21 billion to $213 billion.

Loans increased $3.0 billion, while Equities and Misc. Assets each fell about $5.0 billion.

What, then, was the source of such robust overall growth?

Security Repurchase Agreements rose $103.3 billion, or 30% annualized.

Over four quarters, “repo” Assets surged $302 billion, accounting for 77% of Broker/Dealer Asset growth over the period.

Let’s take a brief diversion from Z.1 data.

M2 “money” supply surged $1.044 TN over the past year, or 7.3%.

Institutional Money Fund Assets (not included in M2) jumped another $390 billion, or 20.8%.

Year-to-date, the S&P500 has returned 28.9%.

The Nasdaq Composite is up 31.6%.

The Semiconductors (SOX) have surged 55.5%, with the Nasdaq Computer Index up 45.8%.

The Banks (BKX) have gained 31.3%.

Treasury bonds (TLT) have returned 16.9%.

Investment-grade corporates (LQD) enjoy a 2019 return of 17.5%, with junk bonds (HYG) returning 13.3%.

Gold has gained 15% so far this year, with Silver up almost 10%.

Real estate prices have continued to inflate, along with private businesses, art, professional sports franchises, collectible, etc.

It has indeed been the spectacular “everything rally.”

Such extraordinary asset inflation is possible only with some underlying Monetary Disorder.

I have argued that international securities finance is at the epicenter of historic Global Monetary Disorder and resulting runaway asset inflation and Bubbles.

When a new Z.1 report was available during the mortgage financial Bubble period, I would immediately jump to the Fed’s “Total Mortgages,” “Agency- and GSE-Backed Securities,” and “Asset Backed Securities” pages.

I would then move on to “Fed Funds and Security Repurchase Agreements” (i.e. “repo”).

These days, I go directly to “repo” data for illumination of this period’s key source of Monetary Disorder.

Q3 did not disappoint.

Total “repo” (“Federal Funds and Security Repurchase Agreements”) Liabilities jumped another $222 billion during the quarter to $4.502 TN, the high going back to Q3 2008.

Over the past year, “repo” surged a record $932 billion, or 26.1%.

For perspective, “repo” Liabilities rose on average $51.9 billion annually over the past five years.

And the $932 billion gain during the past four quarters is more than double the biggest annual rise over the past decade (2010’s $422bn gain that followed the $1.672 TN two-year crisis-period contraction).

Ominously, the past year’s gain also surpasses the previous record four-quarter gain ($824bn) for the period ended in June 2007.

“Repo” Assets (as opposed to Liabilities) surged $1.087 TN over the past four quarters to a record $4.813 TN.

Who holds these Trillions of “repos”?

Broker/Dealers lead with $1.467 TN, followed by Money Market Funds at $1.173 TN; Rest of World at $781 billion; Foreign Banking Offices in U.S. at $403 billion; and the Fed’s recently acquired $203 billion.

In extraordinary growth, over the past year “repo” holdings have increased $302 billion for the Broker/Dealers; $252 billion within Money Market Funds; $145 billion for Rest of World; $98 billion at Foreign Banks in the U.S.; and $203 billion at the Fed.

Total Debt Securities (TDS) gained $1.020 TN during the quarter, or 8.9% annualized, to a record $46.742 TN.

This huge quarterly expansion was second only to Q1 2004’s $1.177 TN.

For comparison, TDS increased $270 billion during Q2 and $449 billion during Q3 ’18.

TDS increased $2.115 TN over the past year.

For perspective, this is 50% above the average annual growth over the past decade and the largest expansion since 2007.

TDS ended September at 217% of GDP (slightly below Q1 ‘13’s record 223%).

Total Equities were down somewhat ($222bn) for the quarter to $49.560 TN, or 230% of GDP.

And while this was below Q3 2018’s record 243% of GDP, booming Q4 equities markets will push this ratio back toward all-time highs.

Total (Debt and Equities) Securities ended Q3 at a record $96.302 TN, or 447% of GDP (below Q3 2018’s record 458%).

For perspective, Total Securities posted previous cycle peaks of 379% of GDP during Q3 2007 and 359% at Q1 2000.

Subdued equities put a damper on the Bubble in perceived household wealth.

Household (and Non-Profits) Assets increased $749 billion during Q3 to a record $130.218 TN.

And with Household Liabilities up $176 billion to $16.386 TN, Household Net Worth increased $573 billion during the quarter to a record $113.832 TN.

For perspective, Household Net Worth peaked during Q3 2007 at $71.346 TN.

Household Net Worth has almost doubled from the $60.221 TN trough back in Q1 2009.

Surely helping explain the resilient U.S. consumer, Household Net Worth jumped $3.726 TN over the past year and $10.854 TN in two years.

Household Net Worth-to-GDP ended September at 528% (down slightly from Q4 17’s record 532%).

Previous cycle peaks were at 492% of GDP during Q1 2007 and 446% at Q1 2000.

U.S. securities/“repo” finance is clearly a major source of liquidity for the markets as well as the real economy.

Yet this Bubble Dynamic is undoubtedly global, with international securities finance instrumental to inflating securities and asset markets around the world.

A Bloomberg article this week referenced a $9.0 TN European “repo” market.

There is also a large repo market in Japan, as well as throughout Asia.

How much finance to leverage global securities is originating out of the likes of Hong Kong, Singapore and Shanghai?

How much global “repo” finance has been flowing into U.S. debt markets?

Rest of World (ROW) holdings of U.S. Assets increased $397 billion during Q3, down sharply from blistering Q2’s $1.017 TN and Q1’s $2.250 TN.

After the remarkable Q4 decline ($2.125 TN), ROW holdings are up an astonishing $3.664 TN in nine months, surely a significant contributor to booming asset prices and general Monetary Disorder.

In three quarters, ROW holdings of U.S. Debt Securities surged $959 billion, or 11.4%, to a record $12.137 TN.

Treasuries jumped $510 billion (to $6.775 TN); Corp Bonds $346 billion (to $3.956 TN); and Agency Securities $93 billion (to $1.171 TN).

Notably, ROW U.S. “repo” Liabilities jumped $292 billion, or 43%, in nine months to $1.207 TN.

How much of this ROW market activity – securities buying and “repo” finance – emanates from global “repo” and off-shore financial centers funding leveraged speculation in U.S. securities?

Markets now relish “clarity.”

A “phase 1” U.S./China trade deal has, at long last, been inked.

The Tories big election win ensures a decisive Brexit.

Meanwhile, the (King of Asymmetric) Fed has essentially signaled no rate hikes until after next year’s election (more likely the 2021 inauguration).

Any inkling of instability would certainly elicit additional monetary stimulus.

Perhaps bond markets are beginning to have an issue with all this.

Is the Fed really going to expand its balance sheet $500 billion to quell any potential year-end “repo” market pressure?

Today’s backdrop becomes even more reminiscent of fateful 1999 (and Y2K).

Britain’s election

Victory for Boris Johnson’s all-new Tories

The Conservatives’ capture of the north points to a realignment in British politics. Will it last?

BRITAIN’S ELECTION on December 12th was the most unpredictable in years—yet in the end the result was crushingly one-sided. As we went to press the next morning, Boris Johnson’s Conservative Party was heading for a majority of well over 70, the largest Tory margin since the days of Margaret Thatcher. Labour, meanwhile, was expecting its worst result since the 1930s. Mr Johnson, who diced with the possibility of being one of Britain’s shortest-serving prime ministers, is now all-powerful.

The immediate consequence is that, for the first time since the referendum of 2016, it is clear that Britain will leave the European Union. By the end of January it will be out—though Brexit will still be far from “done”, as Mr Johnson promises. But the Tories’ triumph also shows something else: that a profound realignment in British politics has taken place. Mr Johnson’s victory saw the Conservatives taking territory that Labour had held for nearly a century. The party of the rich buried Labour under the votes of working-class northerners and Midlanders.

After a decade of governments struggling with weak or non-existent majorities, Britain now has a prime minister with immense personal authority and a free rein in Parliament. Like Thatcher and Tony Blair, who also enjoyed large majorities, Mr Johnson has the chance to set Britain on a new course—but only if his government can also grapple with some truly daunting tasks.

A cold coming they had of it

On a rainswept night the Conservatives marched into constituencies long seen as Labour strongholds (see Britain section). Blyth Valley, an ex-mining community in the north-east where Tories have for generations been the enemy, fell before midnight. Wrexham, Labour turf for more than 80 years, declared for the Conservatives at 2am.

Great Grimsby, a struggling northern port held by Labour since the second world war, was taken soon after. By dawn it was clear that the “red wall” of Labour constituencies, which stretched unbroken from north Wales to Yorkshire, had been demolished.

Mr Johnson was lucky in his opponent. Jeremy Corbyn, Labour’s leader, was shunned by voters, who doubted his promises on the economy, rejected his embrace of dictators and terrorists and were unconvinced by his claims to reject anti-Semitism.

But the result also vindicates Mr Johnson’s high-risk strategy of targeting working-class Brexit voters. Some of them switched to the Tories, others to the Brexit Party, but the effect was the same: to deprive Labour of its majority in dozens of seats.

Five years ago, under David Cameron, the Conservative Party was a broadly liberal outfit, preaching free markets as it embraced gay marriage and environmentalism. Mr Johnson has yanked it to the left on economics, promising public spending and state aid for struggling industries, and to the right on culture, calling for longer prison sentences and complaining that European migrants “treat the UK as though it’s basically part of their own country.”

Some liberal Tories hate the Trumpification of their party (the Conservative vote went down in some wealthy southern seats). But the election showed that they were far outnumbered by blue-collar defections from Labour farther north.

This realignment may well last. The Tories’ new prospectus is calculated to take advantage of a long-term shift in voters’ behaviour which predates the Brexit referendum. Over several decades, economic attitudes have been replaced by cultural ones as the main predictor of party affiliation. Even at the last election, in 2017, working-class voters were almost as likely as professional ones to back the Tories.

Mr Johnson rode a wave that was already washing over Britain. Donald Trump has shown how conservative positions on cultural matters can hold together a coalition of rich and poor voters.

And Mr Johnson has an extra advantage in that his is unlikely to face strong opposition soon. Labour looks certain to be in the doldrums for a long time (see Bagehot). The Liberal Democrats had a dreadful night in which their leader, Jo Swinson, lost her seat.

Yet the Tories’ mighty new coalition is sure to come under strain. With its mix of blue collars and red trousers, the new party is ideologically incoherent. The northern votes are merely on loan. To keep them Mr Johnson will have to give people what they want—which means infrastructure, spending on health and welfare, and a tight immigration policy. By contrast, the Tories’ old supporters in the south believe that leaving the EU will unshackle Britain and usher in an era of freewheeling globalism. Mr Johnson will doubtless try to paper over the differences. However, whereas Mr Trump’s new coalition in America has been helped along by a roaring economy, post-Brexit Britain is likely to stall.

Any vulnerabilities in the Tories’ new coalition will be ruthlessly found out by the trials ahead. Brexit will formally happen next month, to much fanfare. Yet the difficult bit, negotiating the future relationship with Europe, lies ahead. The hardest arguments, about whether to forgo market access for the ability to deregulate, have not begun. Mr Johnson will either have to face down his own Brexit ultras or hammer the economy with a minimal EU deal.

As he negotiates the exit from one union he will face a crisis in another. The Scottish National Party won a landslide this week, taking seats from the Tories, and expects to do well in Scottish elections in 2021. After Brexit, which Scots voted strongly against, the case for an independence referendum will be powerful. Yet Mr Johnson says he will not allow one.

Likewise in Northern Ireland, neither unionists nor republicans can abide the prime minister’s Brexit plans. All this will add fuel to a fight over whether powers returning from Brussels reside in Westminster or Belfast, Cardiff and Edinburgh. The judiciary is likely to have to step in—and face a hostile prime minister whose manifesto promises that the courts will not be used “to conduct politics by another means or to create needless delays”.

Led all that way for birth or death?

There is no doubting the strength of Mr Johnson’s position. He has established his personal authority by running a campaign that beat most expectations. His party has been purged of rebels, and their places taken by a new intake that owes its loyalty to him personally. Having lost control of Parliament for years, Downing Street is once more in charge.

Mr Johnson will be jubilant about the scale of his victory, and understandably so. But he should remember that the Labour Party’s red wall has only lent him its vote. The political realignment he has pulled off is still far from secure.

China in 2050: will it be a global player or split the world economy?

Country’s economic rise and modus operandi is endangering diplomatic, trade and tech links

Louise Lucas

BEIJING, CHINA - APRIL 25: Chinese President Xi Jinping proposes a toast during the welcome banquet for leaders attending the Belt and Road Forum at the Great Hall of the People in Beijing on April 26, 2019. (Photo by Nicolas Asfouri - Pool/Getty Images)
With a $14tn economy, China's president Xi Jinping has reason to celebrate © Getty

Xi Jinping, China’s strongman leader, was in an expansive mood as he presided over celebrations marking the 70th anniversary of the People’s Republic in October.

China, he said, with a “proud civilisation spanning over five millennia . . . will write a more brilliant chapter in our new journey toward the realisation of the two centenary goals and the Chinese dream of great national renewal.”

The twin goals, to be achieved by 2049, are the “rejuvenation of the Chinese nation” both economically and territorially by reunifying with Taiwan.

Mr Xi has reason to be grandiloquent. China’s $14tn economy is second only to the US; Standard Chartered reckons that on the basis of purchasing power parity, China will take the number one slot as early as next year. Even in nominal terms — depending on how you analyse the data — the Chinese economy is expected to surpass the US at some point in the 2030s.

China is also the world’s largest trading nation in goods, according to management consultancy McKinsey, and Chinese and Taiwanese companies account for more than a fifth of this year’s Global Fortune 500. It ranks in the world’s top two countries for receiving and giving foreign direct investment and is the second biggest spender on research and development at some $300bn last year.

China is also represented in international institutions. Its citizens sit at the top of global bodies like the International Telecommunications Union and — until Meng Hongwei was detained for reportedly confessing in a Chinese court to taking bribes — Interpol.

Once dismissed as a copycat maker of cheap gadgets, China now rivals the US in technology, sparking a new arms race in areas such as artificial intelligence and fifth-generation telecoms networks.

“Technology is arguably at the centre of the changing relationship between China and the world,” wrote McKinsey in a report about the country’s global relations.

While China needs access to foreign markets to support tech development, it also wants to increase the market share for local technology players. Other countries are paying “close attention” to whether China breaks from global trade to focus on its domestic market, the report says.

This scrutiny reflects the inconvenient truth Mr Xi did not bring up in his anniversary speech: China’s rise and modus operandi have created waves across the globe, threatening foreign relations and imperilling trade, tech and capital flows.

The big question for the future is whether it will backtrack and become an integrated part of the global economy or whether the current decoupling will turn into a massive rift. This would create a two-gear world economy — much as has happened with the “splinternet”, bifurcated between China and the rest of the world.

The Sino-US trade war and consequent tariff rises threaten to unstitch global supply chains as manufacturers move to cheaper shores in south-east Asia and elsewhere. The broader tech war and concerns over national security has put chipmakers and others on notice that they can no longer deal with blacklisted Chinese companies — US national carriers, for example, have been banned from using Huawei as a supplier.

But the backlash from America’s own tech giants — many of which have long griped at China’s intellectual-property theft and uneven playing field in terms of market access and subsidies — shows how much they want access to the nation’s market. Huawei is on its third licence extension enabling US companies to work with it despite the ban.

How the blacklisting of Huawei plays out will dictate the course of future relations in tech. An outright ban would, many analysts argue, be an own goal — forcing China to ratchet up its efforts in self-sufficiency and cutting American players out of a 1.4bn-strong market.

But caving in does not guarantee an open door. China has flexed its muscle in other industries such as airlines, hotels and movie producers, all of which have been called upon to choose between acquiescing or rebelling.

China’s insistence on its sovereignty over the independently ruled island of Taiwan has snagged the likes of Marriott International. The hotel group was accused of “seriously violat[ing] national laws and hurt[ing] the feelings of the Chinese people” when it listed Taiwan as a country in some online forms. It apologised and changed the forms.

Others have been less swift to apologise, including the cartoon show South Park. The show’s producers tweeted a fake apology following its “Band in China” episode that satirised censorship in the country. They said: “Like the NBA, we welcome the Chinese censors into our home and our hearts. We too love money more than freedom and democracy . . . We good now China?”

Yet it will take more than plucky cartoonists to stand up to China — multinationals who want to serve the whole world will need to tread carefully.

One question is whether bending to China’s will can jeopardise business elsewhere — say, from flocks of millennials spurning sneakers or movies from companies that make what they see as unpalatable choices.

Accessing China’s market may look less attractive if it means being shunned by an entire generation of consumers across the rest of the world.

Trump’s Rocky Road to a $50 Billion China Deal

What Goes DownU.S. farm and energy exports to ChinaSource: USDA, CEICNote: 2019 figures year to date October.

By Nathaniel Taplin

After a nervous few weeks, investors may finally get what they want for Christmas. Like many presents these days, it comes from China.

President Trump has agreed to a limited trade deal with Beijing, The Wall Street Journal reports, although neither the president nor Chinese negotiators have yet made an official statement.

The apparent outline runs as follows: China ramps up purchases of farm, energy and other goods to $50 billion in 2020 and likely offers additional concessions on intellectual property protection or financial services. In exchange, the U.S. nixes new tariffs planned for Dec. 15 and halves existing tariffs on $360 billion of Chinese goods.

As investors have seen many times before, deals involving the mercurial Mr. Trump and his inscrutable Chinese peerXi Jinpingcan fall apart at the last minute. Still, markets are already celebrating: China’s Shanghai Composite rose sharply and U.S. stock futures were up 0.4% Friday.

The immediate question-mark overhanging the current deal is the $50 billion figure. China has been dragging its feet for weeks, claiming its own needs don’t justify such large purchases. What has changed?

U.S. agricultural exports to China were just $10 billion in the first 10 months of 2019, down from nearly $20 billion in 2017 before the trade war began. U.S. oil, fuel and lubricant exports were $4 billion over the same period, also about half their 2017 levels. Boosting agricultural and energy exports back to $30 billion or so, therefore, looks achievable, insofar as it would simply put trade flows back where they were.

U.S. agricultural exports to China were just $10 billion in the first 10 months of 2019. Photo: johannes eisele/Agence France-Presse/Getty Images

The real question is where the next $20 billion comes from. The overall level of U.S. agricultural exports to the world, while down slightly in 2019 from 2018 levels, has actually been remarkably stable despite the trade war. In 2017, U.S. agricultural exports in the first 10 months of the year were $112 billion. In 2019, after two years of bruising trade conflict with China, they were also $112 billion.

If U.S. farmers somehow massively ramp up production, that risks further pushing down global prices as Brazilian and European goods ditched by China flood back onto global markets. If U.S. farmers don’t raise production that much, China can take back a share of U.S. exports by offering higher prices, but that will make U.S. products less competitive elsewhere, including in the U.S. itself. The U.S. could end up exporting a lot more to China but then sending far less to the rest of the world—or even importing more from Canada and other trading partners as U.S. food prices rise.

Similar questions need to be asked about any “other goods” purchases included in a deal. Does this really represent net new demand for American products, or will it just shift trade flows around again? One possibility: China decides to temporarily stockpile U.S. goods on a gargantuan scale for political reasons, which is perhaps the plan.

Other aspects of the potential deal also deserve investors’ scrutiny. For example, China has already opened its financial-services sector to an extent over the past two years, and has already beefed up intellectual-property enforcement since 2014 with a new system of special IP courts.

Lower tariffs, higher exports and better intellectual-property enforcement are all good things.

But to gauge the real, long-term impact for the U.S. economy, investors will need to read the fine print.

Preparing For The End Of The Cycle: December Update

by: Daniel Schönberger
- Since I started my series in October 2018, twelve out of the fourteen stocks covered outperformed the S&P 500 and would have been a good investment.

- Job growth is slowing down, earnings are stagnating, but yet the S&P 500 is rallying from all-time high to all-time high.

- Nevertheless, in my opinion, it is not the time to invest for the long term right now.

I started my “Preparing for the end of the cycle” series about a year ago - the first article about 3M Company (MMM) was published on October 15, 2018. During the last few months, I did not provide an update - my last article about the stocks covered in the series is from May 2019 - as I did not consider it to be necessary or make much sense.

Despite the dark clouds on the economic sky, the stock market is still rushing towards new all-time highs and the chances to hunt for real bargains are very limited. I expected the stock market to have reached its cycle peak by now, which is obviously not the case, and the US stock market (and maybe also the global economy) continues to ride on the edge of a razor blade.
What If?
Would it have made sense to invest in the S&P 500 (SPY) in the meantime? Maybe!
Since October 15, 2018, the S&P 500 increased about 14%, which is a solid performance. After the stocks tumbled last year in November and December, the performance since the beginning of 2019 was quite impressive, with all three major US indices rushing towards new all-time highs in the last few weeks.
If I would have invested in the fourteen stocks I covered in my series, the performance would have been much better. Aside from two stocks - 3M Company and Henry Schein (HSIC) - all 12 other stocks covered in the series outperformed the S&P 500 during that time frame, with Mastercard (MA) and Moody’s Corporation (MCO) leading the list (both gained about 45% in value).
The performance of these fourteen stocks underlines two aspects. First of all, the list of stocks I selected to be great long-term investments obviously have the potential to outperform the market (even the two lagging stocks have the potential to outperform over the long run).

It also shows that investing in these stocks about a year ago would have been very profitable, and by not investing in these stocks I missed out on large profits. These stocks gained in value, as these companies have really superior business models, and I am really convinced that all of these stocks are good long-term investments.
But we also have to acknowledge that the gains during the past 13 months are probably not just the result of fundamental outperformance. To give an example: Moody’s could report great quarterly results, with revenue increasing 15% YoY and adjusted diluted earnings per share increasing 27%.

Despite these impressive results, we have to ask if a 45% price increase is justified for Moody’s with the business being pretty consistent over time. Without disputing that Moody’s is an excellent business, the price increase since October 2018 was probably not just driven by fundamentals but also by the market sentiment, which will lead to overvaluation and drive the stocks to unjustified high prices.
Why So Hesitant?
You might ask why I am so hesitant to invest in these stocks right now, as it is quite obvious that each company is a great business (I told you so myself). In its essence, the answer is very simple, but when discussing it, the matter can become very complex. The short answer to the question: the market is not only overvalued but we are at the end of the cycle, which is not a good time for long-term investments.
I assume the short answer will not be enough to satisfy or convince you, and therefore, we will go into more detail about the current state of the (United States) economy. When looking at the fundamental data and the thousands of indicators, metrics and numbers we can use, there are several indicators showing that the economy is still in great shape and other indicators are sending clear warning signals. Our job is to interpret the different signals and metrics we can use and construct a story describing what the market and the economy will do in the next few years.
When looking at the different metrics, we have to recognize that some indicators are rather leading indicators, while other indicators are rather lagging the economy. When examining these indicators, we see some kind of order and chronology at which point in time these different indicators are reacting to market news or are maybe indicating a recession. Some indicators might hint towards a recession as early as 24 months before a recession, and other indicators will not react until after the recession.
There are also huge differences about the quality of these signals - some are easy to interpret and send clear signals, while others leave much more room for interpretation. And still others frequently send false signals, making the quality questionable. In the following sections, I will present some indicators I consider to be reliable.
We start by looking at the labor market. The unemployment rate is currently 3.6% and the lowest rate it has been in decades (it was lower at the beginning of the 1950s). But the unemployment rate is not really a good early warning indicator for a recession. We should rather look at the initial unemployment claims, which will react earlier.
This number is stagnating at a low level and not really indicating any problems - it has been fluctuating around 220,000 weekly initial claims for unemployment insurance. So far, we see no real signs that the number is dramatically increasing.
It is not really improving, but it is also not getting lower. We can also look at the number of monthly added jobs (the nonfarm payrolls), which is still high (above 100,000, which is often considered to be an important threshold), but the number is slowing down.
We can also use the weekly working hours in manufacturing as a good early warning indicator.
The weekly working hours declined from 41.0 hours in 2018 to 40.3 hours right now. Usually, the number of working hours started declining before a recession, as companies won’t fire people right away, but rather reduce the working time (either reduced number of overtime hours or simply not working full-time any more).
In the last recession, the weekly working hours started declining, as the economy was already in a recession.
In the next section, we are looking at the treasury yields and the actions of the Federal Reserve, as both are tied together. Right now, the yield curve, which is just a graphical representation of the different treasury yields, is more or less flat on the left-hand side and a bit steeper on the right-hand side.
The “normalization” of the yield curve in the last few weeks was interpreted as a positive sign by some market participants after the yield curve has been inverted a few months ago, but it is actually a bearish sign, as these are the classical steps that happen before a recession: the yield curve is inverting more and more over time, the typical next step is the Fed lowering the Federal Funds rate (in most cases several times), and the left-hand side (short-term) of the yield curve is reacting to the actions of the Fed and the short-term treasury yields are declining, which leads to a normalization of the yield curve.
(Source: Own work based on numbers from U.S. Deparment of Treasury)
As often in the past, the Fed called the lowering of the Federal Funds rate just a “mid-cycle adjustment”. But aside from the lowering of the Federal Funds rate, the Fed also started to increase its balance sheet again: after the balance sheet was reduced from $4.5 trillion to about $3.75 trillion, the balance sheet is above $4 trillion again. In my opinion, the Fed knows very well that we are at the end of the cycle (or very close to the end) and is trying to ease the inevitable fall (which is the Fed’s job).
Another fundamental number I didn’t pay much attention to in my past macro articles is the reported earnings. When analyzing individual companies, I always pay attention the reported earnings, but I never focused on the reported earnings of the S&P 500. According to Multpl, the trailing 12 months' earnings were basically flat between December 2018 and June 2019 (shown by the monthly data), but most  companies could still beat estimates, as expectations have been lowered. With almost all companies having reported quarterly results, earnings declined 2.3% in the third quarter, according to FactSet (data from mid-November).
A week later, Proprietary Research reported earnings decline of only 0.4%. For the fourth quarter, analysts are expecting earnings to decline in the very low single digits (about 1%) compared to the same period a year before. Not to long ago, earnings growth was expected to be above 10%. When looking at the earnings decline during the last two recessions, the situation right now is not really comparable, as we saw declines in the mid-double digits, but when considering the rising US indexes against the background of stagnating or even slightly declining earnings, one must wonder.

Black Friday last week and Cyber Monday this week demonstrated once again that consumer spending is still very healthy (and responsible for about 70% of the US economy). On Black Friday, online shoppers spent about $7.4 billion (at the time of writing, I didn’t have numbers for Cyber Monday). While companies like Visa (V) or Mastercard are profiting from high consumer spending, which is rising about 20% compared to the year earlier, many companies have stopped investing, which becomes obvious when looking at 3M Company or Graco Inc. (GGG), for example.
Where To Go From Here?
I know it sounds frustrating - especially when looking at the performance of these stocks - but I still would not buy stocks right now. Considering the even more stretched valuation levels - US stocks increasing more than 20% on average (measured by the S&P 500), but earnings are stagnating - should make us even more hesitant if it is a good idea to buy stocks right now.
When looking at the P/E GAAP TTM, 3M Company and Henry Schein seem to be cheap (trading at 20 or below), and when looking at the price-to-free cash flow (which might be the best among the simple valuation metrics), there even more companies trading below 20: aside from 3M Company (trading at 13.92) and Henry Schein (trading at 15.67), Facebook (FB) is trading at 16.28, Alphabet (GOOG) is trading at 17.06, Accenture (ACN)  is trading at 19.25 and Graco is trading at 19.78.
In my article about a year ago, I calculated an intrinsic value of $140 for 3M Company, and it would be one of the very few stocks on my buying list right now (but it has to decline at least 10% from current valuations to be attractive). And the stock is also interesting for its dividend, which would be above 4% when buying for $140.
I still believe it pays off to be prepared early and to have a watchlist of stocks to invest in. It is better to know what companies to invest in when the price is right and just having to execute than watching a certain stock (or several stocks) decline suddenly and first having to do the research to see whether the stock could be a good pick.
Nevertheless, I might have been publishing my watchlist too early, as the stock market seems to take a lap of honor to celebrate the great run it had during the last decade. Maybe we should not stop investing entirely and still pick great stocks when bargains arise, but it was right to slow down and reduce the amount of money invested in the stock market about one or two years ago - despite the run, the downside risk is extremely high and bargains are limited.

The Federal Reserve Has Been Quietly Increasing the Size of Its Money-Market Interventions

By Alexandra Scaggs

The Federal Reserve is offering a larger amount of short-term cash loans.

The Federal Reserve has been intervening more aggressively in money markets as it attempts to keep interest rates from rising around the end of the year.

On Monday, the central bank again increased the amount of short-term cash loans it plans to offer banks to ensure U.S. interest rates remain stable later this month.

It now plans to offer $25 billion in cash loans for the 28-day period ended Jan. 6, up from $15 billion previously.

Last week, it increased the size of a 42-day facility for the period ended Jan. 13 by $10 billion as well.

That extra $20 billion doesn’t substantially change the total amount of cash loans made by the New York Fed, which is tasked with keeping interest rates within the policy band targeted by the Fed.

It does, however, illuminate the challenge the central bank faces in the corner of money markets where trading desks lend cash to one another, known as the repo market.

In repo transactions, traders sell government securities for cash on a short-term basis, agreeing to buy back the securities at a premium on a predetermined future date, usually one to 90 days later. (“Repo” is short for repurchase agreement.)

The central bank has been active in that market since mid-September. Around Sept. 17, a series of events tied up cash on banks’ balance sheets in government securities, and drove short-term interest rates sharply higher. The Fed intervened with repo transactions, easing some of the pressure.

It isn’t unusual for the Fed to participate in repo markets. Before the financial crisis, the central bank implemented its monetary policy by lending out cash in repo markets, albeit in smaller amounts.

But the end of the year could bring more upward pressure on interest rates, and once again challenge the Fed’s ability to maintain rates within its targeted band. Strategists say that is true even though the Fed is buying $60 billion of Treasuries a month—purchases that ordinarily would tend to pull rates lower.

Here’s why: Year-end is an especially tricky time for banks and their bond-dealer subsidiaries.

Global regulators measure banks’ importance to the financial system, and their requirements for those lenders, based on a snapshot of their balance sheets at the end of the year.

Requirements for the biggest banks are the most stringent,

The effect is that global banks will have an incentive to substantially reduce the size of their balance sheets as the end of the year approaches. That could make them less willing to lend cash in the repo market, driving rates higher.

To address that pressure, the central bank could offer more cash loans for up to six weeks to tide banks over until January.

Repo deals in themselves don’t shrink bank balance sheets, according to Mark Cabana, strategist with Bank of America Merrill Lynch. But longer-term repo transactions should give banks confidence that they will have sufficient cash at the end of the year, he wrote in a recent note. That would allow them to plan ahead and shrink their balance sheets in other ways.

That means more bank trading desks will likely want to borrow from the Fed for a several-week period ending in January. That trend has already started, according to Fed data.

Not only has the central bank has increased the size of repo transactions that end in January, but demand was unusually high for past 42-day transactions.

Take, for example, the $25 billion facility that the Fed opened on Nov. 25, essentially agreeing to lend cash until Jan. 6. There were $49 billion of bids for that facility—almost twice the volume of repo transactions on offer.

The Fed also offered a $25 billion facility on Monday, which will provide a cash loan until Jan. 13. Banks’ trading desks submitted $42 billion of bids for that facility.

None of the Fed’s other repo transactions in the past two weeks had demand that outpaced the amount on offer.  

All of this raises the question of why banks are short on cash reserves in the first place. That has to do with both the central bank’s recent efforts to shrink its balance sheet and the global response to the financial crisis.

Global regulators require banks to hold on to a large store of reserves and high-quality assets thanks to rule changes meant to eliminate the need for bailouts. Some banking functions can only be done in cash, however, so banks often need to pledge their high-quality assets—government securities—in exchange for cash.

Until recently, banks had more than enough reserves to fulfill their needs for cash and regulatory requirements.

But then the Fed started to shrink its bond portfolio. Cash reserves at banks diminished as the lenders bought debt securities the central bank once would have snapped up.

Their excess reserves have declined by more than 35% since the end of 2017. That was apparently too much of a drop; the mid-September funding crunch indicated some scarcity of reserves.

The Fed has started purchasing bonds again since then. It is doing so to boost reserves enough to relieve funding pressures, not to ease monetary policy outright. It is considering other options to ease funding pressures as well, but it probably won’t implement any of them until next year.

So those $60 billion in monthly Treasury purchases don’t quite count as quantitative easing.

According to Cabana, they may not even be sufficient to ease upward pressure on rates at the end of the year.

Israel and the Emerging Crisis of the Secular and the Religious

By George Friedman

Elections normally don’t interest us at Geopolitical Futures. The passage of personalities who preside over the realities of a nation does not usually affect our work.

But there are times when electoral politics reveals something of the underlying reality of a nation.

That is the case in Israel now. It is at a juncture where the nation is so divided on issues so fundamental to the nature of Israel that the normal political process has frozen and a crisis that can affect the entire region is being revealed.

The crisis revolves around two questions: What does it mean to live in Israel, and what does it mean to be an Israeli? Such questions are common in nations, particularly invented ones, like the United States or Israel.

The American regime was invented by the founders, and inevitably, it failed to answer crucial questions, particularly around the issue of whether the states were governed by the federal government or were self-governing.

This was tied to the question of whether the principles of the Declaration of Independence, particularly the claim that all men are created equal, are fundamental to American life. Even this was a flawed settlement that haunts the United States to this day. The debate was settled at Gettysburg and other small towns during the Civil War, which left over 600,000 dead.

In Israel’s case, it could claim continuity for 2,000 years, and it could claim that Israel was at the center of Jewish life.

But the Israel that was created by its founders was invented. Between ancient Israel and the state that was created in 1948, vast swathes of history took place, and the Jews, scattered among many nations, were part of that sweep.

The Israel that was founded in the 20th century was a republic, not a kingdom ruled by the line of David. It was a Jewish republic, but that in itself was an invention.

A Nation Like Any Other?

The question of what Israel was and what it meant to be an Israeli has never been settled. Even the question of who can claim to be a Jew is in dispute.

Whether someone can become a Jew and then claim the right of return and the right to be an Israeli citizen is a battlefield in Israeli politics.

One faction, the Orthodox, claim the sole authority to conversion – but there are several schools of Judaism, so the Orthodox claim creates inevitable friction with other groups.

The Orthodox argue that Israel should not be an ordinary liberal democracy built around secularism, and that it must draw its laws from traditional sources: the Torah, Talmud, Midrash and others.

These books are not only complex but subject to controversy, even among the Orthodox, who have had several millennia in which to debate the issues.

But the Orthodox argue that Israel today is the Israel that fell to the Romans, resurrected.

That Israel was governed by the laws of the book and the learned who interpreted its meaning.

Israel’s founders, however, were not Orthodox; they were deeply secular, and their political debates revolved around the issues of their time: socialism, liberalism and so on.

Their dream was to be a nation like any other, to be the Jewish incarnation of the French Revolution. Vladimir Jabotinsky, the intellectual father of Menachem Begin and Benjamin Netanyahu, once said that he dreamt of a day when Jewish criminals were arrested by Jewish policemen.

It is a banal statement, but it reveals the heart of the Zionist project. Unlike the Orthodox, who saw themselves as a light unto the nations, the Zionists, David Ben-Gurion and Begin saw something that was far more precious to them than the Orthodox vision.

They wanted a place where Jews could be safe and govern themselves, to be criminals or policemen as they willed, one nation among many.

For them, modern Jewishness was forged by the oppression of the diaspora, and redemption was a place they could simply be men and women.

These were two radically different visions of Israel. Initially, the most extreme of the Orthodox Jews opposed the creation of Israel, claiming that it could be resurrected only by the coming of the Messiah and that any attempt to do so by ordinary men and women was apostasy.

This was of course an extreme view and did not represent a broad spectrum, but the idea that Orthodoxy ought to define what Israel was became an ever-present theme.

For example, whereas all Israelis are subject to military service, students at yeshivas are exempted because of the Orthodox claim that the study of the sacred texts is a duty essential to the state of Israel.

But the Orthodox made more claims – including, for example, that certain activities should be limited on the Sabbath – as the faithful in all religions do, dictating what was proper and improper behavior and attempting to make it a matter of law.

Benjamin Netanyahu comes from the tendency in Zionism that was as secular as the socialists but that was inclined to support relatively free markets and, above all, a vigorous and, if necessary, aggressive treatment of Israel’s enemies.

The difference was that the left assumed that there could be a political settlement with neighboring states, while the right assumed that this was unlikely and could be attained only through a crushing defeat.

Both shared the idea of Israel as a state at or near war, but one thought this condition permanent, and the other was trying to craft a solution.

The Orthodox had political power.

The Israeli political system encouraged the formation of small and idiosyncratic parties, which meant that no one party could win a majority in parliament and all governments were formed through negotiation.

The result was that the religious parties, of which there were several, were uniquely positioned when it was time to form a government.

They always had some role in coalitions, but with Netanyahu becoming more assertive and alienating other parties, the religious became a majority.

The Wild Card

All of this was complicated by the decline and fall of the Soviet Union. In the 1980s, a trickle of Jews arriving in Israel from Russia turned into a torrent.

The Russian Jews were almost completely secular.

They were Jews because the Soviet regime treated them as a separate nationality.

They became the wild card in the Israeli system.

For a long time, they did not settle in, but they were a massive force and they took two positions.

First, they readily accepted that the Arabs posed a danger and supported an aggressive policy against them. At the same time, they were by nature secular and had little respect for the Orthodox Jews.

The Russians and the Orthodox became over time the foundation of Netanyahu’s coalition.

But the tension between the Orthodox parties and parties dominated by the Russians grew intense.

The Orthodox were far more interested in their issues than in a range of other issues confronting Israel. They felt, of course, unease with the Palestinian presence in Israel, as well as the secular presence.

But what they prioritized most was extending Jewish traditional law to all aspects of society. The Russians were also hostile to the Palestinians, but they wanted to be left alone by the Orthodox.

This led to a second identity crisis. The Israeli parliament had Palestinian members. Israel had from the beginning considered itself the Jewish homeland, but Netanyahu hoped to appease the Russians and the Orthodox by formalizing this concept and effectively making Judaism the official religion.

That raised a question: What would then be the status of Israeli Palestinians, some of whom were Muslim and some of whom were Christian? Secularism meant accepting the idea of religious diversity, even though Israel was regarded as a Jewish homeland.

This problem had been finessed by arguing that Israel was a place where all Jews and people of other faiths were welcomed. The proposal to formally render non-Jews outsiders was in a way logical, but subtly changed the meaning of Israel.

Two intense cross-currents, always present but contained, tore through the system.

The question of the relationship between secularism and Orthodoxy was brought to a head by the Russians, who were not the only opponents of Orthodox Jews’ power, but gave these opponents electoral weight. At the same time, the logic of Orthodoxy and the exclusion of non-Jews from full membership in the country compounded a problem that had been evaded at Israel’s founding.

What precisely was Israel? Was it simply another liberal democracy that happened to have a large number of Jews living there? Or was it the homeland of the Jews, inherently religious and therefore something that ought to be governed by Jewish religious law.

This long-simmering identity crisis has now led to an urgent political crisis in which the electorate is so fragmented that forming a government after two elections has proved impossible.

Religion as a Private Matter?

It is easy to dismiss this as an idiosyncratic Israeli problem, but it is one that faces all countries. Europe is filled with Christian Democratic parties, including one governing Germany. What exactly does that term mean? In some parts of the United States, there is a serious argument that the country derived its principles from Protestantism, and that the separation of church and state falsifies American history and runs counter to the American intent.

The secularism that arose in Euro-American civilization made religion a private matter.

It also made national self-determination a fundamental principle.

What happens when the cross-currents of religion as a private matter and the right of citizens to determine the nation’s fate collide? Constitutions are meant to be bulwarks against this but constitutions can be interpreted in many ways.

In the Islamic world, the claims of the religious over the secular are powerful, as they are in some parts of the United States. In other parts, the power of secularism is overwhelming.

The case of Israel is worth noting because both the secular and religious are powerful, and when the modern Israeli state was invented, they left the question ambiguous.

The matter has not been settled, and it is in different ways the fault line of the Euro-American and Islamic worlds. Israel as a new state, one that left open what it meant to be a Jewish state, is experiencing this new wave of tensions.

China hit by biggest dollar bond default by state company in two decades

Analysts expect further failures as local governments remove support

Don Weinland in Beijing

China’s Tewoo Group has forced investors to take losses on a US dollar bond, marking the largest failure to repay dollar debt by a state-owned company in two decades and provoking fears of a wave of defaults.

The commodities trader, which is wholly owned by the city government of Tianjin, completed an exchange offer this week that made investors take significant discounts on their holdings in the company’s debt.

The offer was “tantamount to a default”, S&P Global Ratings said on Thursday, and is expected to reframe how global investors view the market for government-backed corporate debt.

“The market has been building to something like this,” said Fraser Howie, an independent analyst and co-author of the book Red Capitalism: The Fragile Financial Foundation of China’s Extraordinary Rise. State-owned enterprises “cannot be assumed to be backed by the state when it comes to bond repayment”, he added.

Until this year, no Chinese company backed by the state had been allowed to default on its dollar debt since the collapse of Guangdong International Trust and Investment Company, or Gitic, in 1998. A missed payment on a US dollar bond in February by Qinghai Provincial Investment Group signalled that state support was waning, although the company made the payment within a five-day grace period.

Tewoo’s restructuring represents a radical shift in how the Chinese government deals with failures at debt-strapped state enterprises by forcing investors to take losses.

The restructuring offer, which has been accepted by investors, gave Tewoo bondholders two options. The first was to take deep discounts on four outstanding bonds — one of which, a $300m bond, matures on Monday. The other option was to exchange the Tewoo bonds for that of another Tianjin-based state enterprise and accept far lower coupons.

Given the economic downturn in China, the Chinese government may lack the resources to bail out all defaulting companies and will probably be forced to accept more market-based restructurings, global investors have warned.

“We expect the government to be more selective in where it uses its resources,” said Alaa Bushehri, head of emerging markets corporate debt at BNP Paribas Asset Management in London. “It doesn’t do anyone any good to be in that comfort zone.”

Gitic’s default in 1998 sent a shockwave through Asia’s US dollar debt market as investors were forced to recalibrate anticipated state support for government-owned companies. But the collapse of the company came at a time when the borrowings of Chinese state-owned enterprises were still small.

Today, state groups are some of the largest debt issuers in Asia, and Beijing is wary that an end to the state’s implicit guarantee will force a repricing of risk associated with such companies and drive up borrowing costs. Some analysts expect that Tewoo’s problems, and the lack of support from the city government in Tianjin, are just the beginning of a series of defaults at government-backed groups.

“We believe Tianjin is not an exception and other local governments with deteriorating fiscal profiles might also see eroding support for their uncompetitive and distressed SOEs,” S&P said on Thursday.