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

    Quarterly Review and Outlook

    Thanks to a subscriber for this report from Hoisington Investment Management which doubles down on a bullish bond view. Here is a section:

    The law of diminishing returns is already evident in all major economies as well as on a global scale (Table 1). Global GDP generated per dollar of total global public and private debt dropped from 36 cents in 2007 to just 31 cents in 2017. Diminishing returns is even more apparent in the case of China’s public and private debt, largely internally owned. In terms of each dollar of debt, China generated 61 cents of GDP growth in 2007 and only 33 cents last year. In other words, in the past ten years the efficiency of China’s debt fell 45%. Thus, even in a command and control economy, the law of diminishing returns prevails. The most advanced sign of diminishing returns is in Japan, the most heavily indebted major country, where a dollar of debt in the last year produced only 22 cents of GDP growth. This economic principle applies equally to businesses.

    All economies rely heavily on the business sector to lead the growth process. Yet, a sharp decline in GDP per dollar of business debt occurred in the U.S. during the past nine years, reinforcing the underlying trend since the early 1950’s. In 1952, $3.42 of GDP was generated for every dollar of business debt, compared with only $1.39 in 2017. In the corporate sector, where capital as well as technology is most readily available, GDP generated per dollar of debt fell from $4.50 in 1952 to $2.50 in 2007 to $2.21 last year. The dismal trend in productivity confirms this conclusion. The percent change for productivity in the last five years (2017-2012) was equal to the lowest of all five-year spans since 1952. It was also less than half the average growth over that period.

    Conclusion Important to the long-term investor is the pernicious impact of exploding debt levels. This condition will slow economic growth, and the resulting poor economic conditions will lead to lower inflation and thereby lower long-term interest rates. This suggests that high quality yields may be difficult to obtain within the next decade. In the shorter run, in accordance with Friedman’s established theory, the current monetary deceleration, or restrictive monetary policy, will bring about lower long-term interest rates.

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    PBoC cuts RRR to avoid over-tightening

    Thanks to a subscriber for this report from Deutsche Bank which may be of interest. Here is a section:

    The PBoC announced it will cut reserve requirement ratio (RRR) by 1 ppts for most banks by next week. RRR will be reduced to 16% for big banks and 14% for mid and small banks (Figure 1). This will inject some 1.3tn new liquidity into the banking system. Banks are asked to pay off some 900bn balances from the medium-term lending facility (MLF) on the same day. Net liquidity injection of about 400bn will largely go to small city and rural banks. Lastly, the PBC asks these banks to use the new funding mainly for lending to small businesses.

    We believe the RRR cut should not be seen as a change of monetary policy stance. The economy is doing well; growth stayed strong at 6.8% in Q1, supported by consumption and property investment (see our note here). Hence there is no need to loosen monetary policy. Indeed the OMO rates were raised just last month (Figure 2). We do not expect PBC to cut policy or OMO rates in the coming months. If anything, OMO rates may be raised further.

    The main purpose of the RRR cut, in our view, is to avoid over-tightening on small banks and small businesses. The PBoC will continue to tighten financial regulations and deregulate interest rates under the leadership of the new government. This will lead to higher funding costs, particularly for smaller banks who do not have large deposit base and rely on wholesale funding. Meanwhile, tightening financial regulations, including the expected new regulation on asset management, will affect the shadow banking business. Banks are pressured to move their off-balance sheet lending back on balance sheet (Figure 3). Small businesses are more severely affected in this process, as they have limited access to regular bank loans and rely more on shadow banking. The RRR cut will mainly benefit smaller banks and, with the guidance on lending, will help relieve financing difficulties faced by small businesses.

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    Email of the day on inflationary expectations

    I'm starting to think more and more that we are likely heading into an environment of inflation and slow growth - Stagflation. I emailed you back on February on this topic. Thought you would enjoy this interesting note attached from Ben Hunt’s “Epsilon Theory”.

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    Electric Cars May Be Cheaper Than Gas Guzzlers in Seven Years

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

    Electric cars may be cheaper than their petroleum counterparts by 2025 if the cost of lithium-ion batteries continues to fall.

    Some models will cost the same as combustion engines as soon as 2024 and become cheaper the following year, according to a report by Bloomberg New Energy Finance. For that to happen, battery pack prices need to fall even as demand for the metals that go into the units continues to rise, the London-based researcher said on Thursday.

    The clamor to roll out electric vehicles has grown louder as countries and companies race to clean up smog in their cities and hit ambitious climate goals set by the Paris Agreement. U.K. lawmakers started an inquiry into the market in September, probing the necessary infrastructure and trying to determine whether to bring forward the 2040 deadline to end the sale of gasoline and diesel cars.

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    Higher Libor-OIS Is New Normal But Don't Fret, Says CS' Pozsar

    This article by Liz Capo McCormick for Bloomberg may be of interest to subscribers. Here is a section:

    “BEAT is forcing foreign banks to substitute FX swaps with unsecured funding and also leads to temporary overfunding on the margin,” he wrote. “BEAT explains why cross-currency bases are tighter while Libor-OIS is wider, and also introduces upside risks” to the forward Libor-OIS spread, he wrote.

    The gauge measuring where Libor-OIS is seen moving in coming months -- the June FRA/OIS spread -- reached about 54 basis points this month, from around 18 at the end of last year. It retreated to 44 basis points Friday.

    The impact is strongest in foreign-exchange swaps because the shift is creating excess funding for those headquarters.

    That cash is being lent into the foreign-exchange swaps market, preventing the basis from narrowing for now, wrote Pozsar.

    Total excess funding that may build up at headquarters of European, Japanese and Canadian banks with branches and broker- deal affiliates in the U.S. could tally as much as $450 billion, he estimates. To the extent that this money had been raised in FX swaps at headquarters, the change may reduce demand for dollars via the basis swaps market, he says.

    Even without the tax effect, Libor has been rising amid a deluge of Treasury-bill issuance since the U.S. debt ceiling was raised in February, which has helped drive bill rates to the highest since 2008. The increase has forced banks to boost commercial paper rates to lure buyers.

    “BEAT is redistributing pressures from the cross-currency basis to the Libor-OIS basis,” Pozsar wrote. “The pressures we should be seeing in cross-currency bases from bill issuance are showing up in the Libor-OIS basis instead. This suggests Libor- OIS could widen more from here.”

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    Labor 2030: The Collision of Demographics, Automation and Inequality

    This report from Bain & Co. by Karen Harris, Austin Kimson and Andrew Schwedel may be of interest to subscribers. Here is a section:

    We expect the magnitude of workforce change in the 2020s to match that of the automation of agriculture from 1900 to 1940. However, the transition of farm workers into the industrial sector was spread out over four decades. In the case of the automation of manufacturing, the impact was over a shorter time period (roughly 20 years), but the share of labor force in manufacturing jobs was relatively small in the US. Investment in automation is likely to proceed moderately faster than agricultural automation or manufacturing automation unless other forces act to impede its progress, and it will affect a larger percentage of the total workforce.

    The tension between the push to offset slowing labor force growth with automation and the pull to slow automation's rollout to prevent massive disruption will play out over the next 10 to 20 years. But once the first companies begin deploying new forms of automation, others are likely to follow suit rapidly to stay competitive.

    The base-case scenario
    Based on the magnitude and speed of change, our base-case scenario could result in about 2.5 million jobs per year lost or not created because of automation. Previous transformations provide an interesting comparison. The automation of agriculture transformed national economies and disrupted labor markets, culminating in the Great Depression. But if that event occurred today, scaled to the current population and labor force, it would displace 1.2 million workers per year. The rate of reabsorption from the automation of agriculture was about 700,000 workers a year.

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    Pimco Sells Australia Banks, Property Bonds as Risks Climb

    This article by Ruth Carson and Andreea Papuc for Bloomberg market be of interest to subscribers. Here is a section:

    Risk assets are vulnerable to a correction as valuations approach fair value, Thakur and John Dwyer, vice president and credit research analyst, wrote in a report.

    “This risk becomes more important as we transition to a period of gradual tightening of monetary policy by global central banks,” according to the report. Asset prices offer little buffer to the risk of possible shocks resulting from negative growth surprises or higher-than-expected inflation, they said.

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    Gundlach Disagrees with Mnuchin and Powell

    Thanks to a subscriber for this article by Robert Huebsche for Advisor Perspectives summarizing Jeff Gundlach’s talk for DoubleLine clients yesterday. Here is a section:

    He said that deficits have historically shrunk in non-recessionary periods and risen during recessions. “We are late in the economic cycle,” he said, “and it is unusual that the deficit is expanding.” He said that this is driven by political reasons, and noted that the fact that we are adding stimulus “has never happened before.”

    Deficit problems will move to the forefront by the end of this year, he said. The deficit is getting a lot worse and there will be “a lot of bonds supplied to the market,” he said. The supply of bonds was about $650 to $700 billion in 2017, he said. It will be $1.2 to $1.3 trillion in 2018, in addition to quantitative tightening (QT) as the Fed contracts its balance sheet, according to Gundlach. There could be another $600 billion in tightening, he added.

    If there is a recession the deficit will get worse, he said, but QT will stop. Either way, investors should expect $2 trillion in supply.

    ”If quantitative easing (QE) was a tailwind for financial assets, then QT must necessarily be a headwind,” he said.

    The unique conditions that prevailed in 2017 are over, Gundlach said. The VIX is above 17, he said, which is higher than at any time in 2017. “We have lived the entire last month and a half at VIX levels higher than in 2017,” Gundlach said. As a result, the markets turned in the greatest Sharpe ratio ever in 2017, but he said that has flipped in 2018.

    “We’ve gone from an easy to a very tough investing environment,” Gundlach said.

    Gundlach predicted that the S&P 500 will have a negative rate-of-return this year. “My conviction is high,” he said, “higher than that the 10-year yield will break to the upside.

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    Bigger U.S. Auctions in Shorter Time Seen Boosting Yields

    This note by Brian Chappatta for Bloomberg may be of interest to subscribers. Here is a section:

    Bond traders have to contend with both larger auction sizes and a condensed schedule when the U.S. Treasury sells $28 billion of three-year notes and $21 billion of 10-year notes on March 12. To JPMorgan Chase & Co. strategists, that combination signals a weak reception. Last month’s offerings, the first since 2009 to increase in size, priced at yields higher than the market was indicating heading into the sales. The 3- and 10-year auctions are usually spaced out over two days, but when they came on the same day in December, yields also missed higher.

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