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David Fuller and Eoin Treacy's Comment of the Day
Category - Fixed Income

    Italy's President in Spotlight as Government Quest Turns Chaotic

    This article by John Follain for Bloomberg may be of interest. Here is a section:

    Italian President Sergio Mattarella takes center-stage as he weighs whether to give law professor Giuseppe Conte a chance to lead a populist government following a last- minute wobble over the candidate’s suitability for the post.

    Mattarella is due to announce his decision as early as Wednesday after Conte, 53, was put forward by Luigi Di Maio of the anti-establishment Five Star Movement and Matteo Salvini of the anti-immigrant League. A flurry of reports in Italian media cast doubt on Conte’s premiership before it even began, prompting Five Star and the League to reaffirm Conte’s candidacy on Tuesday evening.

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    Email of the day on valuations, Dow/Gold and anti-trust:

    Thanks for your comments which are very interesting, especially your focus on technology and its potential to alter radically the investment landscape.

    I have 2 points of my own to make. Using gold as the standard of value for stocks is interesting but I would think valuation metrics are more useful. As you know the Shiller PE, derived by comparing the S&P to the 10-year moving average of real corporate earnings- GAAP (not adjusted)- is at the highest level since the TMT bubble popped in 2000. The ratio of market value (the Wilshire 5000+) to GDP was at all-time highs in January. We have lived through a decade of extraordinary monetary policy (almost zero interest rates and QE), which is now being reversed. I think S&P market value to S&P sales may also be at all-time highs, but I may be wrong about that.

    So the starting point is pretty rich. The PE is at 25 times 4 quarter GAAP earnings, implying a 4% earnings yield. The Moody's Baa 20-year bond yield is around 4.6% so the equity premium has been negative the last 5-6 years for the first time since 1961 when the Bloomberg series started. On average equity holders over this period have earned a premium of 1.62% to reward them for investing in the riskier part of the capital structure, but now they must pay for the privilege.

    However, this does not address your major point about the enormous earning potential of companies involved in future technology. Now a standard criticism of your point is that competition between businesses will reduce the excess profits to "normal profits". What economists call "consumer surplus" consists of the extra value that is transferred from businesses to consumers for free due to the operation of the competitive market which eliminates excess profits.

    This flows from the ideal world of independent competitive enterprises. Anti-trust laws in the USA have been around since 1890 (Sherman Anti-Trust Act) and were designed to cause real world behaviour to better approximate the theoretical. 

    What I have found interesting is that Anti-Trust is no longer as big a deal as it was when I was a student. In fact, when Mark Zuckerberg testified he named 5 or 6 tech companies that are competitors of Facebook's. In this list he mentioned WhatsApp and another company (Telegram?) that he has already bought and perhaps one or two others. He also mentioned Skype, which Microsoft has bought. The big tech companies have the where with all to buy smaller rapidly growing companies and maintain tight oligopolies and thus earn outsize profits. I doubt whether many of these purchases would have passed muster from the Department of Justice's Anti-Trust division one or two generations ago.

    So the key may be to watch politics and see whether the populists at some point turn their attention to Anti-Trust.

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    Email of the day another email on the CAPE and the merits of cash

    In your 30th April response to my email, you say as follows "The only problem I have with comparing the current environment to that which prevailed from the early 1960s is that the market spent 13 years ranging from 2000 to 2013 so it would be unusual to begin another similar range so soon after the last one ended"

    My response:  Yes, it is true that it would be unusual to "commence a similar such range so soon after the last one ended."  However, in this circumstance, there are a range of other very unusual related circumstances.

    In the last 10 years, we have had a unique period of historically extreme money printing with very little consumer prices inflation as measured by the official CPI number, but this extreme period of money printing has caused very high asset price inflation - pushing many sectors back up into fairly extreme valuations as measured by historical norms.

    We can also look at this phenomena from another. If we look at Professor Robert Shiller’s cyclically adjusted price/earnings ratio series commencing 1880, we can see that secular bear markets have typically ended with a single digit CAPE - at the end of a secular bear market, the cyclically adjusted P/E has been in the range of 5-7 in 1982 and 1921.

    By contrast, the January 2018 peak in the US cyclically adjusted P/E of 33 was the second highest instance since 1880 - only being surpassed by the dot com peak in 2000 but surpassing the 1929 peak by a small margin.

    So, by this (Shiller CAPE) normally fairly reliable valuation measure, the US share market on broad averages is at a fairly extreme level. I think it is fair to say that if you buy expensive assets, you should expect poor to bad average real returns over the following 10 years or so.

    One last point to you 30th April comments, to the section where you say "The stock market is a better hedge against inflation than bonds because companies have the ability to raise prices and therefore dividends while bond coupons are fixed."  In a period of rapidly rising inflation like the 1970s, all listed securities including shares and bonds tend to do poorly because of the rapidly rising discount that needs to be applied when valuing such assets. By contrast, in Australia at least, during the 1970s, cash and hard assets like gold and commercial property were better investments. 

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    Beyond the Dollar Everything's Just Noise for Emerging Markets

    This article by Netty Ismail, Ben Bartenstein, Lilian Karunungan and Alex Nicholson for Bloomberg may be of interest to subscribers. Here is a section: 

    The combination of higher debt levels and share of debt denominated in foreign currency means many emerging markets are now more exposed to dollar appreciation than in 2009, amid signs the robust growth in developing economies may be slowing, the Institute of International Finance said in a May 17 note.

    While the U.S. Treasury will sell some of its largest offerings since 2010 this week, a slew of Fed speakers may reiterate plans for gradual rate increases.

    The selloff in developing nation currencies is hurting other assets.

    Emerging-market local-currency government bonds declined for a sixth week, the worst run since 2016. Developing-nation stocks retreated 2.3 percent last week.

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    Hands Tied and Swords Bent, Emerging Markets Battle the Dollar

    This article by Srinivasan Sivabalan for Bloomberg may be of interest to subscribers. Here is a section:

    But that’s not the ominous undertone. It’s about how the traditional fortifications of emerging markets -- strong oil and commodity prices -- are failing to protect developing-nation currencies from the onslaught of a stronger dollar.

    Look at the chart below. In January, developing-nation currencies and commodities fell together and rose back in tandem. But this time, while the Bloomberg Commodity Index is extending gains, currencies have collapsed. This divergence suggests that a strong U.S. dollar is more decisive for risk appetite than commodity prices.

    That’s bad news for countries such as South Africa and Russia. The ruble, for instance, is now moving in the opposite direction to oil even though it’s the country’s biggest export earner. Their usual positive correlation was destroyed by a four-day decline in the currency in the wake of enhanced U.S. sanctions.

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    ECB's Villeroy Sees Rate Hike Quarters, Not Years, After QE

    This article by Piotr Skolimowski, Jana Randow and Alessandro Speciale for Bloomberg may be of interest to subscribers. Here is a section:

    European Central Bank policy maker Francois Villeroy de Galhau said the institution’s first interest-rate increase could come “at least some quarters, but not years” after policy makers end their bond-buying program.

    In an interview in Paris, the French central banker played down concerns about the euro area’s first-quarter economic slowdown and signaled that the ECB is still likely to halt quantitative easing this year. He said inflation will resume its acceleration in coming months, with underlying price pressures set to strengthen as the bloc’s temporary weakness passes.

    “We will probably give additional guidance for the end of the year for the timing of the rate hike and the contingencies,” Villeroy said in a Bloomberg TV interview with Francine Lacqua.

    “We’ll see exactly how we formulate it. We’re predictable, and it’s a clear virtue of our gradual normalization path, but we are not precommitted.”

    ECB policy makers have yet to formally discuss the future of their QE program. Purchases are currently scheduled to run until at least September, totaling more than 2.5 trillion euros ($3 trillion), and officials expect interest rates to stay at current record lows until “well past” the end of net buying. Maturing debt will be reinvested.

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    Italy Set for New Government -- Then a Snap

    This article by John Follain for Bloomberg may be of interest to subscribers. Here is a section:

    5. Who would likely win?
    Opinion polls show the League -- the rebranded, formerly secession Northern League, once known for deriding residents of the country’s south as beggars, thieves and good-for-nothing rednecks -- has gained the most from two months of bargaining. Its support rose to 24.4 percent from 17.4 percent in the March vote, according to an SWG opinion poll carried out May 3-6. Five Star is still the biggest single party, slipping half a percentage point to 32.2 percent. (A center-right alliance including the League and the Forza Italia party of Silvio Berlusconi, the four-time former prime minister, rose to 38.5 percent from 37.1 percent.) If Salvini’s League strengthens in the next election, he could decide to break with Berlusconi and finally form a coalition with Di Maio. This time around, Di Maio’s insistence on excluding Berlusconi was a primary obstacle to a populist coalition government.

    6. Why does this matter?
    Italy is facing political decisions and economic problems that affect other nations too. At more than 130 percent of gross domestic product, Italy’s debt is second-highest in the euro area, after Greece. The European Commission called the debt “a major source of vulnerability” for Italy and has been overseeing the country’s efforts to reduce spending. Underlying problems remain in Italy’s banks, including cronyism with many lenders too entwined with politicians, unions and foundations of all shapes. Mattarella has warned that the timing of the next elections could jeopardize the 2019 budget, which has to be approved by the end of the year, and unsettle financial markets. And nobody’s fully forgotten Five Star’s past talk of a referendum on leaving the euro.

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    Email of the day on the long-term outlook and potential for inflation

    In your 10/April long-term themes review, you said: "So, the big question many people have is if we accept the bullish hypothesis how do we justify the second half of this bull market based on valuations where they are today? ..... However, the answer is also going to have to include inflation. "

    My thoughts, not in any particular order:

    If we look at Robert Shiller's research ~1870-now, on the US share market, his studies show that historically, extreme valuations in the US share market (as assessed by cyclically adjusted P/E ratio) have always been followed by poor average real return over the following 10-20 years."
    You point to inflation as to how a secular bull market (in nominal terms implied) can now occur for the US share market (by implications I think you are reflecting on the US share market) over say the next 10-15 years (say).  You use the experience of Argentina and Venezuela as justification for your argument - where from memory, there was hyperinflation in the periods to which you refer.

    First, I do not think you are suggesting hyperinflation for the USA .... mismatch 1.
    For Argentina and Venezuela, I think their currencies also crashed. I do not think you are suggesting the US dollar is going to crash. Possible mismatch 2.
    Rather than a comparison with Venezuela and Argentina, perhaps a better analogy is to the period in the USA following the late 1960s, when US share markets where at quite high valuations (though not nearly as expensive as now on a CAPE basis). Following the peak valuations of the late 1960s, the US share market went sideways (with some large dips) over the next 16 years or so.

    In summary, I am not sure that your argument is particularly robust.  Yes, the technological revolution is a critically important new phase which will have a huge impact over the next 10 and 20 years..... and there may well be a secular bull market in that sector ... but does that really mean that the technology sector by itself will take the whole S&P500 with it in a secular bull market for the next 10 or 20 years?

    Your thoughts?

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    Why High-Flying U.S. Home Prices Are About to Get Another Jolt

    This article by Vince Golle for Bloomberg may be of interest to subscribers. Here is a section:

    The framing of homes, or putting up roofs and walls, accounts for 15 percent of the cost of construction. A composite measure of the cost of lumber for framing rose 16 percent from December to March, according to data from Random Lengths, a publisher of information on wood products.

    And it’s not just lumber. A Labor Department gauge of prices paid at the producer level for construction inputs -- everything from particleboard and plumbing to concrete and insulation -- was up 5.1 percent in March from a year earlier, the biggest annual advance in nearly eight years.

    So far, neither higher home prices or a four-year high in mortgage costs have been enough to dissuade buyers. Results of the Conference Board’s consumer confidence index on Tuesday showed 1.7 percent of the group’s respondents in April planned to purchase a new home in the next six months, matching the highest share in this expansion.

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