Category Archives: Investiv Daily

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The Economic News is Very Good, But Keep An Eye On the FED and GDP This Week


  • Housing is showing inflationary signs but still offers an opportunity to profit from the rising trend as a downturn is unlikely and not expected in the short term.
  • Amidst all the positive news, manufacturing turned negative. Yet despite this, stock valuations keep going up, increasing the risk.
  • In the week ahead: the FED’s decision and GDP data. It looks like stable weather in the near future.

Introduction

The last sequence of economic data was very positive. In this article we are going to discuss the important data coming out this week and analyze the information released last week. Then we’ll combine it with the current situation on the market and, as always, analyze the risks and rewards.

Housing

Existing home sales came in at 5.5 million which is the highest in the last 10 years. This is great news and indicates a continuation of the positive trend in the real estate market. Distressed sales from foreclosures are at 6%; down from last year’s 8%.

figure 1 home sales
Figure 1: Existing home sales since 2013. Source: FRED.

Some might think that a new housing bubble is being created. Unfortunately, a clear answer to that can only be given in hindsight. There are several worrying factors, but every bull market climbs the wall of worry. The most alarming factor is that the number of people renting is growing which may indicate that many are already priced out of the market.

In support of a continued uptrend is that fact that home inventory is low as housing starts are at 1.18 million, which is still subdued when compared to the historical average of around 1.5 million, but much higher than it has been over the last 7 years.

figure 2 housing starts
Figure 2: Housing starts. Source: FRED.

According to Bloomberg, another worry is that many homes are being purchased by “mom and pop” investors with less experience, while institutional investors are ducking out of the market. Institutional investors used to account for 50% of investor foreclosure purchases, but in June that number fell to 38%. More troublesome is institutional investors now only make up 2.5% of the market, down from 9.8% in 2013.

Similarly to the situation we had in 2007, more and more foreclosed homes are bought by amateur speculators, which may be over-inflating the market.

figure 3 third party investors
Figure 3: Third-party investors auction home purchases. Source: Bloomberg.

Housing is cyclical and at some point in the future we will see another down market, but the above mentioned worries do not indicate an immediate decline, which means there is still money to be made in the uptrend. Investors might want to look at building and building materials companies that are trading below their real values and still feeling the consequences of the great recession. But beware of the risks, the downturn will eventually arrive. It might be a soft landing as more new homes are built which smooths out the price increases, or a hard landing similar to the one we saw in 2009.

The S&P/Case Shiller home price index will be published today, and prices are still expected to grow at 5.5% year over year which is very high for housing markets, but if low interest rates continue we might see a few more years of such increases.

The S&P 500

The recent S&P 500 breakout is strengthening on the positive housing data and jobless claims at 43 year lows.

figure 4 jobless claims
Figure 4: Jobless claims. Source: FRED.

So far, 25% of S&P 500 companies have reported positive earnings surprises, further fueling the stock market. Earnings are not growing, but 68% of companies have reported earnings above estimates. As of this weekend, the S&P 500 earnings decline for Q2 2016 was expected to be at -3.7%, and unfortunately, expectations for earnings in Q3 2016 have been constantly falling over the last several months.

According to Factset, Q3 2016 will be the sixth consecutive quarter with declining earnings (-0.1%). Positive analysts don’t expect a return to earnings growth until Q4 2016, but the below figure shows how quickly analysts’ forecasts can change.

figure 5 expected earning growth rate
Figure 5: Expected S&P 500 Q3 2016 earnings growth rate. Source: Factset.

With positive economic news and declining earnings, it is difficult to know where the market goes from here. From a fundamental perspective, the market is getting riskier and investors are paying more for lower returns. The current S&P 500 price earnings ratio has now surpassed 25, indicating that in the long term you should not expect stock returns to be higher than 4%.

figure 6 multpl
Figure 6: S&P 500 PE ratio. Source: Multpl.

Reaching full employment means that companies will have to pay more for employees, and thus have higher costs, which should put more pressure on earnings. This should spur inflation, but we will know more on Wednesday when the FED issues its Monetary policy statement.

The Real Economy

As always, life for the FED will be difficult. Low jobless claims, higher house prices and a higher S&P 500 are all good, but there is always the fear that those are just asset inflation repercussions.

The Philly Fed Manufacturing business outlook survey has turned negative again. As manufacturing is the basis of a healthy and sustainable economy, this might push the FED to postpone rate increases, but we might hear a more positive tone.

figure 6 diffusion index
Figure 7: Current and future general activity indexes. Source: Philadelphia FED.

No matter what the FED says, the week will be overshadowed by Friday’s publication of the preliminary data on GDP. A big rebound is expected given the positive economic activities happening in the last few months. GDP is forecasted to grow at 2.5% in Q2 2016.

figure 7 forecasted gdp
Figure 8: Forecasted GDP. Source: Wall Street Journal.

Conclusion

The current environment is one full of positive news and positive expectations which is very good, but as savvy investors we must always look at ways to protect ourselves. More and more indicators are signaling that we are getting closer to the end of the real economic growth period and entering a bubble period.

House flippers are inflating house prices, stocks are reaching new highs even as earnings are declining—and still expected to decline further—while the real manufacturing economy is not growing. All this mixed data indicates that we are close to a recession and a bear market, but the good times could still last for a while as the FED continues to keep interest rates low. We will watch this week’s news releases and earnings carefully and update you on the new developments. Stay tuned.

 

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Beware of “Thinkless” Investing


  • Passively managed funds do offer the lowest fees but invest in stocks without “thinking”.
  • High positive net inflows into passively managed funds push large caps higher regardless of fundamentals.
  • If non “thinking” investors panic when things turn, large caps will be the worst performers.

Introduction

Today we are going to discuss two related topics: fees and the general market consequences of passively managed investing funds.

Fees are charged by funds for their services, be it active or passive management. Passively managed funds, which have the lowest fees, merely track an index. Over the last several years a trend has developed toward lower fees and passively managed funds which may also be creating a growing risk that equities are held by “weak” hands.  If panic comes, and investors pull their money out, passive fund managers will be forced to sell, creating further market havoc.

We will start by explaining the current situation and trends, and finish with an analysis of what is best for more sophisticated investors.

Current Fees and Trends

In 2015 the average assets-weighted expense ratio was 0.64% for all funds. The expense ratio includes distribution commissions, management, administrative, operating and all other asset-based costs incurred by the fund but it does NOT include transaction fees which are charged directly to the fund’s assets. These transaction fees are not reported and do lower your returns, but if you manage your own portfolio you incur in the same fees so we are not going to account for those.

If we take the current S&P 500 expected average compounded return of 4% and calculate the value of a $100,000 portfolio for the next 30 years with and without fees, the difference comes to a staggering $56,825.

figure 1 difference
Figure 1: $100,000 portfolio with and without fees. Source: Author’s calculations.

 

These fees, that at first look innocuous, contribute to a total income for the industry of $88 billion (2014) per year. The good news is that passive funds charge lower fees with an average of 0.2%, but they still charge a fee and offer only market-like performance, minus fees.

figure 2 expense ratio
Figure 2: Asset-weighted expense ratios. Source: Morningstar.

 

The low fees and strong marketing, and the fact that active management has significantly underperformed over the last several years, has attracted lots of capital inflows into passively managed funds. In the past 10 years, the lowest cost quintile funds attracted an aggregate of $3.03 trillion while the other four quintiles attracted only $160 billion. This has several consequences and creates opportunities for the astute investor. In the last 10 years, 18% of actively managed funds did beat their benchmark which means that over-performance can be found if searched for.

Consequences and Opportunities

As 95% of capital flows go into passively managed funds that simply track an index, this also means that 95% of the money in the markets does not “think.” Funds that track an index simply buy stocks according to their weight in an index and continue buying or selling in relation to their inflows or outflows. As passively managed funds have had constant positive net inflows, the stocks with the largest weights in an index will get the most funds and their share price will grow even higher.

figure 3 net inflows
Figure 3: Net inflows by expense ratio (lowest quintile are passively managed funds). Source: Morningstar.

 

The consequence of so much money going into passively managed funds is that the stocks with the largest weights will go up regardless of their fundamentals. If we check the performance of the top 10 S&P 500 constituents, we will see that their stock prices have gone up in the last 10 years. Of the top 10 (all excluding dividends), the best performer in the last 10 years was Amazon with a 2,318% return, followed by Apple with a 931% return and Facebook with a 311% return. The worst 3 stocks were General Electric with a negative return of -3%, AT&T with a return of 37% and Exxon Mobile with a 38% return.

StockCurrent S&P 500 WeightTotal 10-Year ReturnRevenue GrowthEPS Growth
AAPL2.91%930%1100%2800%
MSFT2.22%117%100%10%
XOM2.08%38%-33%-50%
JNJ1.83%93%40%47%
GE1.61%-3%-28%-74%
AMZN1.52%2318%1100%537%
FB (4 year data)1.48%311%380%250%
BRK1.46%128%218%100%
T1.40%37%150%20%
JPM1.24%109%50%50%
Figure 4: S&P 500 top 10 constituents by weight. Source: Author’s calculations from Yahoo and Morningstar.

The interesting thing is that only AAPL had returns lower than its revenue and earnings per share growth. All the other stocks have seen their prices increase at a much higher rate than their fundamentals. The high net inflows in passive funds pushed the largest weighted stocks higher since passive funds buy regardless of the underlying fundamentals.

Over the same time period the S&P 500 only grew by 66.62%, which is much lower than the above averages. This proves another important point: passively managed funds are forced to have their largest weighting in companies when their share price is at or near a high point and completely skip being invested during the growth period. As a good example, Facebook had its IPO in May 2012 but was only included in the S&P 500 in December 2013 when its stock was already 100% up since the IPO.

Conclusion

Fees should be assessed constantly since high fees are severely damaging to portfolio returns in the long run as they limit the magic of compounding.

One solution is passively managed investment funds that replicate an index performance, minus a small fee. A fee nonetheless, which should still be considered, especially since passively managed funds do not “think” when buying the biggest companies which proportionately constitute the largest weighting in their portfolios. Furthermore, their growth in share price has less to do with strong revenue and earnings growth, and more to do with a passively managed investing trend that attracts lots of capital.

But what happens when the tide eventually turns? A halt in net flows into passively managed funds would force them to sell assets. And since the current net inflows are much higher than those in 2007, the downside risk is also much higher.

Until a recession hits the economy, why fight the trend when you can outperform the S&P 500 by just following the biggest companies of the index as all the passively managed funds buy stocks according to their weight in an index. However, when a recession comes and people start to panic, the same stocks will see the biggest declines due to forced asset sales in proportion with their weight, and the best option will be to “think” by sticking with companies with the best fundamentals.

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Have Recent Market & Currency Gains In Brazil Just Increased The Risks?


  • Brazil’s economy contraction is slowing and the trend is turning positive.
  • The political situation is currently stable but trouble is always around the corner.
  • Fundamentals show potential but also risks as the price to book value is relatively high at 1.4.

Introduction

In April we wrote about Brazil and described it as a good risk reward opportunity as all the bad things had already happened. Brazil’s president Dilma Rousseff had just been impeached, the economy had declined by more than 5% and Brazil’s currency was at historical lows against the dollar.

As Brazil is a young country, rich with natural resources, the investing logic was that Brazil is oversold and undervalued from a longer term perspective. As predicted, the currency has strengthened and the Brazilian stock index has increased. This article is going to discuss the current situation, and take a look at fundamentals and economic factors, in order to see if this improvement is backed up by concrete facts or if it’s just a change in sentiment and Brazilian stocks are now riskier than they were three months ago.

Current Situation

The economic situation in Brazil hasn’t improved since April. While the economy did shrink, it only did so by 0.3% in Q1 2016 which is better than expected as the Brazilian Institute of Geography and Statistics predicted a 0.9% contraction. The economy is still contracting but is shifting in trend. The International Monetary Fund (IMF) forecasts a 3.3% contraction in 2016 and then finally small economic growth in 2017 based on business confidence bottoming out and higher commodity prices. The better than forecasted contraction in Q1 shows that Brazil is on a good path to reach growth in 2017. IMF warns that stronger growth is difficult to forecast as political uncertainties remain.

1 figure - brazil gdp - new copy
Figure 1: Brazil’s GDP per quarter. Source: Trading Economics.

The economic shift in trend was immediately reflected in the stock market. The Brazilian stock index has increased by 10% since April and by 50% since the global stock bottom in January.

figure 2 Bovespa
Figure 2: BOVESPA index. Source: Google Finance.

But on top of the stock index increasing, international investors have also benefited from the stronger Brazilian Real (BRL). The Real has strengthened by 22% in relation to the dollar since January, and 10% since April.

figure 3 BRL USD
Figure 3: BRL per 1 USD last 12 months. Source: XE.

As the 10-year average is 2 BRL for $1, there is still plenty of space for currency gains from Brazilian investments.

figure 4 10 year brl
Figure 4: BRL per 1 USD last 10 years. Source: XE.

When Brazil returns to its normal economic growth rates the currency will return to normal levels, thus there is still a 50% potential gain. But for that gain to be realized a lot of things have to improve in Brazil, starting with its politics.

Brazil has an interim president at the moment, Michel Temer, who is trying to stabilize things by limiting government spending to the inflation rate and limit social benefits. Such moves are already priced into the market, but there is always the risk that a left-leaning party takes over as this is just an interim president which could affect prices to the downside. Elections are planned for 2018 but many invoke early elections, especially the impeached Dilma Rousseff who has called for a referendum for early elections.

Political risk is still the main risk for Brazil. With the markets 50% up, any new political turmoil might bring the markets down quickly.

Fundamentals

A look at fundamentals shows that Brazil is still amongst the lowest priced global markets. The cyclically adjusted price to earnings ratio, which looks at 10-year average earnings, is 8.5 but the current PE ratio is very high at 44.1 due to the economic crisis and high interest rates. The price to book value is also relatively high at 1.4, thus it does not give much downside protection.

figure 5 valuations
Figure 5: Fundamental valuation ratios in international equity markets. Source: Star Capital.

Conclusion

Despite Brazil’s political and structural issues, the country remains a promising one. With a population of 200 million, and with a GDP per capita at only $11,208, there is still plenty of room to grow in order to reach a developed level (for reference, the US’ GDP per capita is $53,041).

In the long term, there’s no reason that Brazil won’t eventually return to its previous growth levels of around 3% annually. In the short and medium term, Brazil still has many issues. Apart from the political issues previously discussed in this article, the country also has a constitution that has been amended 91 times in the last 30 years, indicating an instability that consequently makes it very difficult to plan long term investments.

Since we wrote in April, the economy has improved a bit, but it is still contracting. The mere fact that there haven’t been any political scandals recently is not enough to base an investment case. While Brazil looks cheap, a return to power by Dilma Rousseff or any further indication of early elections may increase its risk and send asset prices down.

Until real structural, economic and political developments are reached, higher asset prices and a stronger currency means more investing risk for foreign investors. Traders might want to grasp the opportunities created by the current stability and positive trend, but long term risk averse investors might want to wait for lower risk with cheaper prices.

 

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Higher Interest Rates Aren’t A Given, But Investors Should Prepare Anyway. Find Out Why.


  • Rates cannot go lower but higher rates would destroy wealth and lead to a recession.
  • The FED is in a difficult position and rhetoric shifts can be expected.

Introduction

It is every central banker’s target, the elusive 2% rate of inflation. We cannot know when, but should expect that it will be achieved and prepare accordingly. Since rising interest rates help to keep inflation in check, once the target is reached, as strange as it sounds, rates should also rise to compensate. This article is going to analyze what is happening, what will probably happen, and how it will affect investments.

Current Situation

The current situation is one of persistently low interest rates on a global scale. The U.S. recently increase short-term rates by a negligible amount, while Japan and Europe continue with their easing policies.

figure 1 historical interest rates
Figure 1: Interest rates in Japan, Europe and U.S. Source: FRED.

Once inflation reaches the 2% target, inevitable consequence will be higher interest rates since it is the only option that prevents inflation from escalating. It’s hard to imagine now, but with all central banks hell-bent on achieving their “goal,” it will become a reality, maybe sooner than most expect. It might take central banks putting money directly into our hands via “helicopters,” but eventually the target will be reached and we will see interest rates come back to normal historical levels.

The FED forecasts its funds rate to be between 2% and 3.5% in 2017. If achieved, it means that all other interest rates, from bond yields to mortgages, will be higher than that. A plausible scenario is that 10-year bond yield is 1.5% higher than the fed funds rate and the expected stock yield 2% above that.

figure 2 FED forecast
Figure 2: FED’s funds rate forecast. Source: Federal Reserve.

Such an evolution means that a lot of things are going to change in financial markets.

Implications of Higher Interest Rates

It’s pretty simple, rates go up, asset prices go down. The consequence is less wealth which leads to lower consumption which leads to a recession. This forecast is unpleasant but is also a reality. Hopefully, the economy will be ready for higher rates.

One consequence of higher rates is that mortgage rates will also be higher. Usually, the 30-year fixed mortgage rate is a few percentage points above the federal funds rate. If you do not have a fixed mortgage, or are unable to buy now while rates are low, your future monthly payments will be higher, leaving less money for investments and consumption.

figure 3 fed and mortgage
Figure 3: 30-year fixed mortgage rate and federal interest rate. Source: FRED.

Higher mortgage rates might influence a decline in home prices. Figure 4 below shows that declining mortgage costs have supported a continuous rise in home prices.

figure 4 mortgage rates and home prices
Figure 4: Home price index and mortgage rates. Source: FRED.

As interest rates go up, so will bond yields. Consequently bond prices must fall. It’s that simple. As bond yields go up, expected stock yields rise as well since stocks are considered riskier and carry a premium. The current expected yield from stocks is around 4% given a PE ratio of 24.85 for the S&P 500. If we add 2% to the expected yield from stocks, we get to 6% which implies a PE ratio of 16.6. Given the current earnings, a PE ratio of 16.6 would mean the S&P 500 would trade at 1447, which is 33% below current values.

In addition to declining asset prices, due to higher expected yields, many corporations have taken advantage of the low rate environment to borrow money. If interest rates go up, financing costs will follow which will lower corporate earnings. Lower corporate earnings means less investments and less investments mean less economic activity.  Therefore, the S&P 500 could drop even further.

On a positive note, savers will appreciate higher rates as they have been getting almost nothing for the past 7 years. Higher yields will also benefit Insurance companies that live off of their float and pension funds that are desperate for higher yields.

Is the Above Scenario Possible?

When this scenario begins to play out, investors will get the short end of the stick as higher rates will directly translate into lower asset prices. This shouldn’t come as a big surprise for investors, since the total U.S. net wealth is $80.3 trillion, of which $37.1 trillion is in real estate and $28.7 is in equity. In total, 80% of U.S. wealth is concentrated in assets whose value is strongly correlated to interest rates.

Higher interest rates mean less wealth, less wealth means less consumption and less consumption leads to a recession. Therefore, it will be very difficult for the FED to implement the forecasted interest rate increases without inflicting a lot of pain on U.S. households.

And then there is the issue with the dollar. Higher interest rates mean a stronger dollar, unless Europe and Japan coordinate their rate increases simultaneously. A stronger dollar means less exports and, again, less economic activity.

Conclusion 

It’s possible, given the above scenario, that buy and hold investors won’t fare as well as medium term traders and active investors might, since the FED will be forced to see saw back and forth with interest rates. Maybe we will see a rate increase in the coming months, but those rate increases will have a negative effect on the economy and household wealth, and the FED will be forced to lower rates again. The implications of this back and forth rhetoric can already be seen in the 6-month U.S. 10-year treasury note yield chart, where yields have experienced constant up and down movements in relation to nothing more than market sentiment surrounding expectations of higher yields.

figure 5 yield
Figure 5: U.S. 10-year treasury note yield in the last 6 months. Source: FRED.

 

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“Helicopter Money” Contagion & A Weimar Germany Type Hyperinflation?


  • Japan is flirting with new and more aggressive monetary easing.
  • Inflation in the U.S. might already be higher than officially reported.
  • Further monetary easing could be beneficial if, and only if, it stays under control.

Introduction

We live in very interesting financial times. With low inflation, central banks are able to inject lots of money into the economy through asset swaps, and still keep interest rates low.

figure 1 balance sheet and sandp
Figure 1: FED balance sheet and S&P 500. Source: FRED.

In theory, more money should mean more growth. Since there has been no inflationary consequence thus far, why shouldn’t central banks just keep injecting the economy with more money?

Figure 1 shows how the increase in available liquidity has influenced asset prices by lowering risk aversion, as the S&P 500 has moved in lockstep with increasing liquidity.

Since there has been no visible inflation, a rumor that central banks might inject even more money into global economies by using so called “helicopter money” is now circulating among certain financial circles.

This article is going to introduce you to what “helicopter money” is, what the real risks of it happening are, what the impact will be on your portfolio, and discuss some investment ideas if it really happens.

What is Helicopter Money?

“Helicopter money” is an idea made popular in 1969 by the great American monetary economist Milton Friedman in his paper “The Optimum Quantity of Money” where he shares the following:

“Let us suppose now that one day a helicopter flies over this community and drops an additional $1,000 in bills from the sky, which is, of course, hastily collected by members of the community. Let us suppose further that everyone is convinced that this is a unique event which will never be repeated.”

The idea is that if you receive more money, you will spend more and thus bring inflation to the target rate. As printing money is done at a minimal marginal cost, there are no constraints on central banks, however, they have not yet resorted to such a measure. The latest rumor of using “helicopter money” was started after Former Federal Reserve Chief Ben Bernanke visited Japan and discussed more creative and extreme monetary policies. The first consequence of more monetary easing is currency devaluation. And last week, just the rumor of more easing saw the Japanese Yen depreciate by 5%.

figure 2 yes usd
Figure 2: JPY per 1 USD in the last 7 days. Source: XE.

No monetary policy seems to work in Japan and its central bank has reached its limit of “asset purchases.” There may be no other option for Japan than to get creative with “helicopter money.” If Japan pulls the trigger, other global economies will follow in order to stay competitive.

Consequences of Helicopter Money

The main consequence of such bold moves would be even more uncertainty. We already have negative interest rates and ballooned balance sheets, for which we have no historical precedent, the same holds for “helicopter money.” With no hard evidence all we can do is guess how such an experiment will end.

The first signs of increasing uncertainty will show up in the currency markets. Figure 2 above showed that even the mention of new monetary measures in Japan sent the Yen 5% lower against the dollar.

“Helicopter money” is always a bad idea with negative long-term consequences, even though in the short run it may provide a “boost” to the economy. Let’s not forget, the same argument was used for the current easing monetary policies, which have yet to “boost” the economy. When easing didn’t work, central banks and politicians opened the easing spigot even more. The same temptation would exist with “helicopter money” and could get completely out of control.

If central banks choose to deploy “helicopter money,” their only focus should be to reach the 2% inflation target for Japan, Europe or the U.S., which according to the FED has not yet been reached.

But increasing the money supplies can become a “monetary addiction,” since it makes it easier for any government to repay its debts and go deeper into deficit spending, which always helps to get reelected. With the coffers full of new money, much less thought is given to the need to repay debt.

figure 3 U.s. inflation
Figure 3: U.S. Inflation rate. Source: U.S. Inflation Calculator.

Even though the Fed says the 2% inflation target has not yet been met, other sources state that the inflation rate is much higher than what is officially reported. The common consumer price index (CPI) is a questionable measure of inflation as it tracks consumer spending and not the real supply of money. The current money supply has been constantly growing which means money is worth less. What’s misleading is the fact that the constant increase in money supply has not translated into higher prices in the last few years.

figure 4 money supply
Figure 4: M2 money supply vs. CPI. Source: FRED.

As the CPI measuring method constantly changes, it’s a good idea to take a look at inflation that doesn’t take into account measuring method changes since 1980. The shadow stats rate of inflation is much higher than official, and in line with the above increases in money supply.

figure 5 shadow inflation
Figure 5: Constant CPI method inflation. Source: ShadowStats.

The true definition of inflation is an increase in the money supply, which always makes it worth less, regardless of what current economic indicators tell you. Rising prices are just a symptom of inflation, and more money put into the system might spur hyperinflation, should central banks decide “helicopter money” is the road to take.

How Will Investments Behave?

With more money flooding the system, the current asset inflation would just continue.  However, there will be sectors that outperform.

As governments start “dropping” money from helicopters, infrastructure companies should be some of the biggest beneficiaries. As more infrastructure gets built, it requires more materials. Since there is a limited supply of commodity resources, it’s inevitable that with more money in circulation, prices rise. Therefore, materials can protect and hedge against inflation.

Conclusion

We don’t know when and if central banks are going to pull the trigger on more monetary easing, but it is a good idea to consider such a scenario and how it could affect the global economy and various investments.

If Japan starts with “helicopter money,” investments there might increase as the Yen devaluates since the revenue of many of Japan’s corporations is derived abroad. A weaker yen also promotes their exports. If “helicopter money” appeared to be working in Japan, Europe would quickly follow since the other forms of monetary easing haven’t achieved the desired result in either country.

In the short run, any additional monetary easing efforts should benefit all equities, which has been the case over the last 7 years. But in the long run, if the easing is not done “properly” (can we expect politicians and bankers to behave properly?) it is almost certain to bring long lasting economic troubles, similar to those Japan has experienced over the last 20 years. One has to wonder why they think more of what hasn’t worked is the best solution.

Historically, all money printing experiments end badly. One of the worst resulted in a World War as Germany was looking for a way to exit its hyper-inflationary crisis. The 1924 100 billion Deutsche marks banknote is an indication of how monetary easing can easily get out of hand.

figure 6 billion mark
Figure 6: German 1924 100-billion-mark note. Source: Solingen.

We can hope that monetary easing doesn’t get any more out of control than it already is.  And that it only continues to inflate asset prices and increase investment returns, as it has done for the last 7 years. But don’t bank on it.

 

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This Commodity May Have Reached Its Bottom. Find Out What It Is In Today’s Article.


  • Fertilizer prices have been declining alongside food prices, but food prices are picking up.
  • Fundamentals give downside protection with some risk coming from short term earnings.
  • The long term outlook is positive with balanced markets and demand growth.

Introduction

In agriculture and horticulture, potash is the common term for nutrient forms of the element potassium (K). It is used globally for increasing agricultural yields and is an essential fertilizer.

From an investing perspective potash has been beaten down alongside other commodities but seems to be close to its bottom. This article is going to elaborate on an investing thesis for potash producers.

Current Situation

Two supply contracts, between the Belarusian Potash Corporation and two major Asian consumers, China and India, are very important for potash prices. At the end of June, India signed on to buy potash at $227 a ton which is the lowest price in the last decade and China signed on to buy at $217 a ton which is 30% less than last year. The low prices are not good news for potash producers, but those prices usually establish a global price floor. Other potash miners typically settle prices with India and China at the same levels.

The low prices are a result of current low food prices after a few years of favorable weather. This resulted in farmers putting-off increased fertilization and $50 billion spent in investments for increased potash production in the last ten years making supply 10% higher than current demand and bringing prices to multi-year lows.

figure 1 potash prices
Figure 1: Potash prices. Source: PotashCorp.

As potash prices are currently 50% of what they were a few years ago, potash stocks are also down more than 50%. However, if prices have bottomed an opportunity might be developing in this slump.

figure 2 potash price
Figure 2: Price movement of the Potash Corporation of Saskatchewan Inc. in the last 5 years. Source: Bloomberg.

Any improvements in the potash market would quickly give a boost to stocks of all potash producers.

figure 3 global potash producers
Figure 3: Global potash producers. Source: K+S.

Before we look at the fundamentals of individual companies, we are going to elaborate on the short- and long-term market outlook.

Market Sentiment

PotashCorp CEO Jochen Tilk stated in his Goldman Sachs basic materials conference this May that potash prices have bottomed and gave a cautious but optimistic view for the future. The basic drivers for potash prices are not contract negotiations, but rather the weather and planting, thus in the short term we can expect potash prices to be correlated to food prices.

figure 4 food prices
Figure 4: FAO food price index. Source: Food and Agriculture Organization of the United Nations.

Several agricultural commodities, such as sugar, soybeans, and coffee have seen significant increases in price this year after prolonged multi-year declines. This indicates that the bottom is likely in or near for most food based commodities. We therefore believe that fertilizer prices have also likely reached their bottom. As food prices increase, applying fertilizers becomes more attractive to farmers and demand increases.

Long Term Outlook

Food price correlations are also the main factor in long term potash prices forecasts. As the global population is expected to be around 10 billion in 2050, arable land is constantly decreasing while global calorie consumption is rising. Therefore, demand for both food and fertilizer should continually increase.

figure 4 arable land
Figure 5: Less land, more demand for food. Source: K+S.

On the supply side there is current overproduction, but as potash is a pure cyclical play, with a turnaround in food prices—also cyclical,—a change in the current oversupply might soon be possible.

By 2020 PotashCorp expects supply and demand to level out as demand is expected to grow in line with demand for food at a few percentage points per year. The current weak demand is expected to normalize with higher food prices, lower inventories and some mine closures.

figure 6 outlook
Figure 6: Potash outlook to 2020. Source: PotashCorp.

In a stable market environment, potash prices could pick up a bit which would be enough to significantly increase profits for producers, as most of them are profitable even with the current low prices and oversupply.

Fundamentals

For a fundamental analysis of the Potash market we are going to use data from the Potash Corporation of Saskatchewan Inc. (NYSE: POT), Mosaic (NYSE: MOS) and Agrium (NYSE: AGU), which are more U.S. oriented.

 PE RatioPrice to BookDebt to EquityGross MarginOperating MarginDividend Yield
POT14.81.70.4531.50%26%7.30%
MOS10.410.3818.20%13.30%3.40%
AGU13.72.20.7326.30%11.20%3.70%
AVERAGE12.971.630.520.250.170.05
Table 1: Potash Fundamentals. Source: Morningstar.

If we are truly at the bottom of the potash cycle, then the above fundamentals actually look very intriguing. With an average trailing PE ratio of 13, potash producers are almost 50% cheaper than the S&P 500. The same holds for their book values and dividend yields, with an exceptionally high dividend yield from POT. It’s exceptionally high because the payout ratio is 120%. In order to sustain the payout ratio POT is taking on debt, however, management is confident that a bottom is in place.

Risks

The main risk is that potash prices further deteriorate, although this risk is minimal as the price floor has been set with the Asian contracts. A further decline in potash prices could be caused by benevolent weather conditions, crop yields remaining high without the need for fertilizer, or low food prices which don’t make it economical to use fertilizer. Seeing that food prices are increasing, this negative scenario seems unlikely, but investors need to be prepared for it. Another thing to be aware of is that none of the companies identified above are pure potash producers, so proper due diligence and specific risks should be assessed before investing.

The second risk may come from the upcoming earnings declines. As the current contracts are 30% lower than last year we can expect lower earnings for 2016. This could put pressure on stock prices even if it seems that the bottom in potash prices has been reached. However, the market may have already discounted any further decline in earnings. More aggressive investors could establish positions now, and more conservative investors could follow the earnings reports  and if bad, with stock prices falling further, buy cheaper.

Conclusion

The potential rewards may outweigh any further downside risk since we have good companies with low PE ratios and high dividend yields, that are still profitable even at these low potash prices. They also have good supply chains in place and low cost production that creates an advantage in the market.

Investors should also remember that a drought in the U.S., or El Nino waking up and destabilizing global food production, would quickly increase food prices as well as the affordability of fertilizers, causing potash prices to rise.

An investment in potash looks like one with limited downside and huge upside potential with a nice dividend yield while you wait, which is something to think about during these long Summer days.

 

Disclaimer: Sven Carlin, the article’s author, is long K+S, AGU and The Mosaic Company, and may initiate a new position in any of the above mentioned companies in the next 72 hours.

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Should You Bet On Small Cap Growth Stocks? Why It May Not Be A Good Option Now


  • Small cap growth stocks only outperform in the two years after market bottoms.
  • At this moment they provide more risk and less returns than the S&P 500.

Introduction

While it’s possible to make money in the stock market, it’s not easy. One thing an investor should know well, and constantly assess, is their exposure to various kinds of stocks, from value and growth stocks to large or small caps. Each type of stock performs differently depending on the economic cycle. However, over the long term small caps and value stocks have outperformed the rest of the market.

In this article we are going to investigate what we might expect from small cap growth stock performance at this moment in the economic cycle.

Small Cap Growth

Small cap growth stocks are companies whose earnings are expected to grow at an above average rate, relative to the market and their market capitalization, which is typically less than $2.5 billion. These companies have tremendous potential and if they manage to become large cap stocks, the returns to shareholders are phenomenal. This is magnified by the fact that mutual funds are often restricted in buying small caps and thus as a company grows there are more and more buyers who can invest.

While the returns of investing in small caps can be very rewarding, the risk is also higher than with large caps. Since the business isn’t as well established, there is a lack of corporate transparency, and more difficulty in attracting capital.

The chart below shows how small cap growth stocks have performed in various cycles since 1980 in comparison to the S&P 500.

figure 1 small cap vs sandp
Figure 1: $100 invested in the S&P 500 vs U.S. small cap growth stocks in 1980. Source: Fidelity, iShares, Author’s Calculations.

In the long term, the S&P 500 outperformed small cap growth stocks even with the standard deviation of returns being much lower (22.33 for small cap growth and 16.2 for the S&P 500). A higher standard deviation of returns means that you can expect more volatility, thus more risk, but as we can see it does not translate into higher returns over the long term. A higher standard deviation means that there will be periods when small cap growth stocks outperform.

In researching the performance of small cap growth stocks through economic peaks and troughs, the conclusion is that small cap growth stocks outperform other types of stocks in the short period after recessions. Investing $100 in small cap growth stocks at the beginning of 2009 would have returned $181 in the next two years and largely outperformed the S&P 500’s $144. However, from 2011 onwards the S&P 500 would have outperformed small caps by 10% in total.

The same situation happened after the 2003 bottom where small cap growth stocks returned $175 for a $100 investment in the two years after 2003 and outperformed the S&P 500 which returned only $142. The same holds for the 1991 recession with two year returns at $170 for small cap growth stocks and $139 for the S&P 500.

So one thing is pretty clear: small cap growth stocks outperform after the economy and the markets have reached their bottom. This is good to know for future recession lows, but does not help much in the current seven-year bull market.

By looking at the data from 1980, small cap growth stocks have underperformed in all the stable growth periods from two years after the bottom to the peak of the market. They also underperform in bear markets and flat markets.

figure 2 performance in bad years
Figure 2: Small cap growth performance in bad and stable years. Source: Fidelity, iShares, Author’s Calculations.

This means an investor would do well to avoid small cap growth stocks at all times except for the darkest recession and bear market periods.

Rationale

Given that long term returns are correlated to underlying earnings, the first thing to consider in order to better understand the performance of small cap growth stocks is valuations. The iShares S&P Small-Cap 600 Growth ETF (NYSEArca: IJT) has a PE ratio of 24.29 and a Price to Book ratio of 2.9, while the iShares Enhanced U.S. Large-Cap ETF (NYSEArca: IELG) has a PE ratio of 19.84 and a price to book ratio of 2.3. Higher valuations make small cap growth stocks riskier, and at the first sign of a recession or tightening of financial markets, investors flee small cap growth stocks, which is the reason for their underperformance in flat and bear market years.

The reason they outperform in the recovery phase of an economic cycle is derived from the above. Since small caps are battered in recessions, their recovery is much better as they start from a lower starting point and have to play catch-up. As soon as they catch up, they begin to underperform as their valuations are usually too high.

figure 3 economic cycle
Figure 3: Stock types and economic cycles. Source: BlackRock.

Also, large caps are more globally diversified and derive about 38% of their revenues from abroad. Small cap growth stocks are mostly concentrated on their focus market and do not have the benefits of international diversification to help them in case of a U.S. recession.

What To Do

Passive investors should rethink their exposure to small cap growth stocks. As most, if not all of the extra returns from the 2009 recession low have been made, they now offer a lower return for more risk than a boring investment in the S&P 500.

However, there is one caveat. During moments of an economic peak like today, merger and acquisition activity intensifies, which should give a boost to small cap growth stocks. If you hold a portfolio consisting of many small cap growth stocks, you might want to select the ones that have a higher chance of being bought out by a bigger company.

 

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Could It Be A Good Idea To Invest In Japan? There’s Upside Potential…


  • Price to book is 1.1 and price earnings ratio is at 15.
  • More monetary and fiscal stimulus can be expected.
  • Even if the economy doesn’t pick up Japan is relatively cheap.

Introduction

We read a lot about how Japan has been in an economic slump for the past 30 years, how incredibly large amounts of quantitative easing have not triggered inflation, and that Japan should be avoided as an investment opportunity.

In this article we are going to see if any of those concerns have merit by looking at the economy, financial markets, fundamentals, currency risks and rewards in order to estimate the rationality of internationally diversifying our portfolio with Japanese stocks.

The Japanese Economy

Japan was an Asian tiger the 1980s and the burst of the 1989 stock market bubble practically eliminated economic growth. Short growth periods are consistently leveled out by recessions.

figure 1 japan gdp
Figure 1: Japan’s GDP growth. Source: Trading Economics.

Even with no GDP growth, unemployment in Japan—which currently sits at 3.2%—is very low. Not as low as it has been historically, but still relatively low when compared to other economies like the U.S. with 4.9% or Europe with 10.1%.

figure 2 japan unemployment
Figure 2: Japan’s unemployment rate. Source: Trading Economics.

Japan is suffering from the same disease as most of the other developed economies, an aging population. The labor force participation rate is slowly but steadily declining and is currently at 59.8% (U.S. 62.7%). As a consequence, labor productivity in Japan has been declining for the last 10 years.

In order to bring the Japanese economy to a more stable growth path the prime minister, Shinzo Abe, has embarked on an incredible quantitative and qualitative easing plan. The easing consists of pushing the interest rate below zero and purchasing stocks and bonds on the open market with the goal of bringing liquidity to the market and hopefully spurring  inflation. The current interest rate is minus 0.1% and the Bank of Japan has largely increased its balance sheet in the last few years.

figure 3 balance sheet
Figure 3: Bank of Japan balance sheet and interest rate. Source: Bloomberg.

Monetary policy isn’t the only reason for such a drastic decline in yields. Because the Yen is considered a safe haven, Japanese securities are often used as collateral. This keeps demand high, which also helps to keep rates low. Even still, this has not been enough to spur inflation and now there are even rumors, seeing how inflated the Bank of Japan’s balance sheet is, that it has limited maneuvering space for more quantitative easing. But, Former Federal Reserve Chairman Ben Bernanke rejected this notion as he met with Shinzo Abe to discuss how Japan can beat deflation and implement more qualitative and quantitative easing. The idea is to use “helicopter money” where a central bank directly finances government spending and tax cuts which should inevitably lead to inflation.

There is no guarantee this will happen, but seeing that Japan has had a decade of deflation, anything is possible. As investors, we should look for investments that will do well in an inflationary environment with high levels of monetary easing.

Current Market Situation

Neither the Japanese economy nor the stock market has grown much in the last few decades.

figure 4 nikkei index
Figure 4: Nikkei index. Source: Yahoo Finance.

However, in the last 5 years it has risen 100% when calculated in the Yen. But given the strong depreciation of the Japanese yen in the last 4 years, it only equates to a 60% rise in US dollars.

figure 5 yen usd
Figure 5: USD vs YEN since 2006. Source: XE.

Over the last few months the Yen has actually appreciated against the US dollar. But new easing possibilities might once again lower the value of the yen, which in the last week alone depreciated 4% against the dollar. Investors have to be careful here and differentiate what is real market appreciation or just currency depreciation that affects the Japanese stock market. On the other hand, as the above two figures show, the stock market moves in sync with the currency thus there is at least some protection, currency wise.

From a global valuation perspective Japan is undervalued. Knowing that many products that we use on a daily basis are made by Japanese companies, it might be a good idea to dig deeper into Japanese stocks.

Japan’s Cyclically Adjusted Price Earnings ratio (CAPE – uses 10 year earnings average) is at 20.7 while the U.S. the ratio is 24.7. The normal PE ratio for Japan is also relatively low at 15.2 which is one of the lowest PE ratios in the developed world.

figure 6 global PE ratios
Figure 6: Global PE ratios. Source: Star Capital.

In the long term, investment returns are correlated with underlying earnings, therefore diversifying internationally with cheaper Japanese businesses makes sense. Especially since many of these businesses operate globally. Plus, Japan has a strong legal system, is transparent and has a long positive history towards international investments.The iShares MSCI Japan ETF has an even lower PE ratio of 13.09 and a Price to Book value of just 1.16 which are both much lower than the iShares S&P 500 Core ETF with a PE ratio of 19.55 and a price to book ratio of 2.8.

Future Potential Catalysts and Risks

The first potential boost the Japanese stock market might get is from the new easing program where the central bank will directly give money to the government. This could weaken the yen and make Japanese products cheaper.

The second boost might come from increased fiscal stimulus. The prime minister already delayed the higher consumption tax implementation and more measures should be expected.

The third potential catalyst could come from better corporate governance. Japanese companies have lots of assets sitting on their balance sheets, including cash, and there is a slow trend towards more buyback programs and higher dividends, although this not the usual way Japanese companies operate.

There is always the risk that the stimulus might not work and that Japan returns to the familiar cycle of slow growth with constant recessions. If that turns out to be the case, the low valuations and attractive Price to Book values Japanese companies have, should provide some downside protection. And the fact that many Japanese companies operate globally further mitigates country risk.

Conclusion

In hindsight, it is always easy to explain what happened. Maybe in a few years people will look at the extra returns generated from Japan as pure logic, seeing that the PE ratio is much lower than the rest of the developed world and balance sheets much stronger.

Unfortunately, investing is not done in hindsight. It takes courage to invest in something where it looks like everything should turn out well but has not yet happened. Given the fundamentals and macro trends, Japan might just be the perfect example of how markets tend to be irrational for longer periods of time, allowing patient investors to make extraordinary returns.

 

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As The S&P 500 Reaches New Highs, Asset Inflation Continues


  • All factors are indicating an artificially created asset inflation.
  • Earnings are expected to decline with economic outlook being constantly revised downwards.
  • Gold is gaining alongside stocks which confirms that all assets are inflated.

Introduction

Amidst all the turmoil from BREXIT, negative interest rates and global downward economic growth forecasts, the S&P 500 has reached a new high. On Monday it closed at 2,137.16 points, overtaking the previous high of 2,130.82 from May 21, 2015. The Monday record was surpassed again on Tuesday and Wednesday, with Wednesday closing at 2,152.43.

figure 1 s and p 500
Figure 1: S&P 500 in the last 5 years. Source: Bloomberg.

This new high isn’t significant in terms of real returns as the market hasn’t really gone anywhere in the last 14 months, but it is significant from a psychological and confidence perspective. In this article we are going to look for the breakout reasons and fundamentals, and analyze potential risks.

Fundamentals

It’s pretty straightforward: if earnings grow then the S&P 500 is also supposed to grow, if earnings decline and the S&P 500 grows we can assume we are in a bubble. At the moment, earnings are not growing and this earnings season will probably be the fifth consecutive quarterly earnings decline. In total, net income is down 18% since its 2014 high.

figure 2 earnigs
Figure 2: S&P 500 index and earnings. Source: Bloomberg.

The 18% decline isn’t that bad when compared to the average 36% earnings decline in recessions since 1936, but currently we are not even close to being in a recession.

Investors seem optimistic and willing to pay a hefty premium for stocks. The current S&P 500 PE ratio is approaching 25 and it has been higher than 25 on only two occasions in the last 100 years, in the dotcom bubble and in the midst of the Great Recession when earnings plunged.

figure 3 S&P 500 pe ratio
Figure 3: S&P 500 PE ratio. Source: Multpl.

As earnings are not growing and fundamentals are deteriorating, there must be something else that creates investor optimism.

Economic Data

As stock prices reflect future expectations, a look at GDP forecasts will give a good perspective on the rationality of the above valuations. In June, well before the BREXIT vote, the World Bank lowered its global growth forecast from 2.9% to 2.4% indicating more trouble for corporations. The International Monetary Fund has cut its forecast for the U.S. from 2.4% to 2.2% for 2016 but expects a pickup to 2.5% in 2017, while the FED expects moderate and stable economic growth at 2% for the next few years. In greater detail, the media highly promoted the 287,000 new jobs added recently but failed to focus on the increased unemployment rate from 4.7% to 4.9%.

One might wonder if the above mentioned data is enough to sustain a PE ratio of 25 as historically the economy has grown faster than 2% and the S&P 500 has had lower PE ratios, again an indication that asset prices are inflated.

Low Bond Yields 

The inflation in asset prices is especially visible in fixed income investments. With 30% of global sovereign debt charging a negative yield, investors push bond prices higher and higher in a desperate search for positive yields. This is further enhanced by the central banks of Europe and Japan actively buying corporate bonds on the market, and even stocks for the latter. As long as central banks relentlessly continue buying securities, it is very difficult for stock markets to experience substantial declines which means that small risks are being smoothed out by monetary policies while the big black looming risk grows bigger and bigger.

Not only that, but capital flows toward fixed income funds are reaching record highs.

figure 4 etf flows
Figure 4: Cumulative fixed income ETP flows in billions. Source: Bloomberg.

S&P 500 Sector Performance

One could argue that the above mentioned corporate earnings decline is mostly the result of lower commodity prices and declining earnings in the energy sector, but only 4 of 10 sectors will see earnings growth in the coming earnings season.

figure 4 earnings per sector
Figure 5: S&P 500 expected earnings growth per sector. Source: FACTSET.

Despite that the energy sector is expecting the worst decline in earnings, its performance in the last 6 months has been the best as things have stabilized a bit. On the other hand, the fact that utilities, energy and materials were the best performing sectors in the last 3 months shows that investors are looking for investments that protect against inflation and have constant, recession-proof yields.

figure 5 sector spdr
Figure 6: S&P 500 sector performance in the last 6 months. Source: Sector SPDR.

The same conclusion related to the search for inflation protective assets can be reached by the looking at the continuing surge in gold prices.

figure 6 gold prices
Figure 7: Gold prices in the last 12 months. Source: Bloomberg.

Gold is usually not correlated with stocks, but from the chart above we can see that both gold and stocks are increasing which again leads toward the conclusion that all asset prices are inflated.

What To Do

It is difficult to be smart in such an artificially created situation, but stock picking and “stick to what you know” might be the best option. You must evaluate the companies in your portfolio and identify how they will perform in the uncertain times that are ahead as asset inflation, possible real inflation in the future, and higher rates will wreak havoc among securities.

Now is the time to be smart. Investors should grasp the opportunities given by the high liquidity but at the same time think of the potential risks if anything changes in the current financial monetary easing system.

 

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Negative Yielding Debt: A Party for Investors or Pure Stupidity?


  • Almost 30% of global sovereign debt comes with a negative yield.
  • The situation is much worse in Japan and Europe than it is in the U.S.
  • Investors should enjoy the asset inflation party while it lasts but also be prepared for the worst.

Introduction

Negative yielding debt seemed impossible and illogical for a long time, but it suddenly became a reality a few years ago and now we are seeing it slowly become the new normal.

This isn’t just strange, it’s dangerous as risk averse investors—like pension funds and insurance companies—are forced to invest in assets that have traditionally been considered safe but that have now become risky, and their returns minimal. Those low returns will result in lower pensions and lower savings which will create new troubles in the future.

This article will analyze how we arrived negative interest rates, what the current situation is globally, and what the long term implications will be for your portfolio.

History and the Current Situation

Negative interest rates started with a few European central banks cutting their interest rates below zero in 2014 (Switzerland and Sweden), followed by Japan in 2016. The EU is not far behind with its 0% interest rate. Apart from central banks’ negative interest rates, high demand for bonds also pushes the yields below zero. With the European Central Bank buying 169 billion of bonds per month with its asset purchase program, it also distorts the markets, and pushes bond prices up, creating negative yields.

It is now estimated that 30% of global sovereign debt has a negative yield.

figure 1 negative yielding debt
Figure 1: Global debt by yield. Source: Wall Street Journal.

Per country, the worst situation is in Switzerland where the complete yield curve is negative, even for bonds maturing in 2049. Germany and Japan have negative yields on debt maturing in 10 years with yields of -0.17% and -0.28% respectively, while The Netherlands and France are not far away with yields at 0.02% and 0.12% respectively. The situation is much worse for debts with shorter maturities.

figure 2 euro yield curve
Figure 2: Euro yield curve. Source: Financial Times.

For perspective, it is wise to compare this to how the U.S. nominal yield curve looks as it is much healthier. If economic news from the U.S. continues to be similar to the latest job news, we could expect an interest rate rise in one of the next FED meetings, which should normalize the U.S. yield curve even more.

figure 3 us curve
Figure 3: U.S. yield curve. Source: U.S. Department of the Treasury.

With longer term yield being above inflation, the U.S. debt market looks much healthier and more rational than the EU or Japanese markets.

Economic Reasons and Implications

Many of the World’s most renowned investors have warned that this negative interest rate experiment in Europe and Japan will backfire. Pimco’s Bill Gross stated that a new supernova is being created and BlackRock’s Larry Fink has warned that it will have huge repercussions on the ability investors have to save and plan for the future.

The main goal central banks had in mind by lowering interest rates was to stabilize the economy and increase employment. However, given the length of time yields have been at zero, or even negative, without the accompanying benefits to the economy, one could conclude that the experiment has not worked. In fact, the World Bank has now trimmed global economic growth prospects from 2.9% to 2.4%.

One of the reasons why it may not have worked, is because the whole world is pushing for liquidity by lowering yields, and the positive effect low yields should have on an economy has been diluted and the only thing that has been inflated are asset prices, which isn’t bad if you are fully invested.

Since central banks were unable to create a healthy inflation rate of 2% with what they deemed the appropriate amount of liquidity, they then flooded the global economy with too much liquidity. And instead of having the desired effect of raising prices, it has actually increased competition with more goods and services being offered, which has lowered prices.

We might now start to see some inflation in the U.S. as the unemployment rate is getting close to the natural unemployment rate but Europe is still far from it with unemployment at 10.1%. Until consumers increase spending and create inflation this negative interest environment will persist and we cannot know when it will change, what we can is prepare for when it will change and analyze the current risks.

Implications for Investors

The most painful consequence of negative yields is that savers are penalized and that investors desperate for any kind of yield pay a high risk premium for low yields. A global snap back in interest rates, or a fall in credit quality, would put the financial world under extreme pressure as investments that are usually considered the safest could lose a substantial amount of value depending on how high interest rates rise, since bond prices move inversely to yields. Goldman Sachs estimates that an unexpected 1% increase in U.S. treasury yields would trigger $1 trillion of losses. If you are highly invested in bonds please be aware of the risks you are running if interest rates rise and ask yourself if the low yield is worth the risk.

Inflation would put pressure on interest rates and companies which cannot transfer increased financing costs onto customers would have huge difficulties in refinancing their debt. The current S&P 500 debt pile is the largest in history and companies are taking advantage of the low interest rates in order to borrow as much as they can.

figure 4 net debt
Figure 4: Net debt issuance/reduction. Source: FACTSET.

Investors should take advantage of the situation as most of the corporate debt is used for repurchases that further inflate asset prices but be careful for the moment when the party stops. At some point, the party has to come to an end someday because corporations are not using the fresh capital to invest but instead are only using it mostly for repurchases and dividends, thus not thinking that much about the future.

Conclusion 

As there is no historical precedent to the current situation, all that one can do is make an educated guess as to when it will end. We all know that this situation is artificial and we also know that it has not been that beneficial to the global economy in the last few years.

As the more mature investors reading this will know, the economy works in cycles and we will see this asset inflation end but we cannot know when. When it does turn, it will certainly be an ugly scenario as investors will sell inflated assets in panic, corporations will find it difficult to refinance debt and central banks will not have maneuvering options with interest rates already negative.

But, as central banks continue to hope that more of the same—which is clearly not working—will eventually work, and which according to Albert Einstein is the exact definition of stupidity, let us enjoy the party while it lasts, hope that it will last for a long time, and always stay prepared for an eventual change.