Rhyming with the late 1990's

Short market summary

Stocks soared to new highs. US yields made new highs as well. Early Friday morning the Five Year hit 1.90 and Tens 2.41 (Gundlach had previously mentioned 2.40 as an area which might be appropriate for a tradable rally). The belly has led the way with 5’s up over 6 bps on the week to close at 184 and tens up just 2.5 to 235.8. The 5/30 spread closed at a new low of 116, having been 140 right after the election.  US spreads to Germany exploded, with the Schatz making a new low yield of nearly -75 bps, and the US 2 year at 112, a spread of 187. Green March Eurodollar to Euribor (EDH19/ERH19) vaulted from around 160 pre-election, to a new high of 204 on Friday.  The euro threatened 105 during the week before coming back to close unchanged at 105.91. Gold made a new low (GCZ6 1178) as a result of USD strength. I would also note news reports that India might ban gold imports. India this week also instituted ‘banking reform’ by banning high denomination currency, sure to cause a short term hit to growth.  (The global war on cash continues to gain steam).  India’s economy is a bit larger than Italy, which has its referendum vote next Sunday. (India $2.1T and Italy $1.8T).  The strong dollar was also a negative for oil which closed -0.30 on the week at 46.06 (CLF7). However, it was down almost $2.00/bbl on Friday as “Saudi Arabia pulled out of planned talks with non-OPEC nations including Russia as disagreements about how to share the burden of supply cuts stood in the way of a deal to boost prices just days before a make-or-break meeting in Vienna.” ( BBG) 

With respect to US monetary policy, a December hike is priced. In terms of the March 15 meeting, I would call the odds just under 25%, with Feb/April Fed Fund spread at 5.5 bps and Dec/March ED spread 5.75 bps. There was fairly heavy selling on the front part of the ED curve this week, EDZ6 closed -2.25, EDH7 -3.0 and EDM7 -4.0. Could some of the weakness in front be related to EM demand for USD funding? A couple of charts on that attached. Employment report on Friday. Italy referendum next Sunday.

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There is a financial newsletter, the title of which has stuck in my head this week, ‘Things that make you go…hmmm’ written by Grant Williams. My efforts won’t be mistaken for Mr Williams’ as his writing is witty and articulate; he delves deeply into topics and draws investment conclusions.  My style, particularly this week, is more along the lines of Del Griffith, at whom Neil Page storms, “Here’s a good idea, when you’re telling these little stories, have a POINT, it makes it SO much more interesting for the listener.” No points here, just a couple of things that make me go ‘hmmm.’ 

For example, this, from Bespoke Investments:  The US' percent of world equity market cap has surged to 37.78% since the election, highest weighting since early 2006.

At first blush, one might say, sure, the US has completely recovered, and really, the gain in share is only a few percentage points. Signs of recovery abound, like the FHFA raising the conventional mortgage limit from $417k to $424,100, the first increase since 2006. Like other data, home prices have reached their previous highs from nine years ago.  

Let’s go deeper into the idea of US market cap as a percent of the globe. US GDP as a percent of world GDP was as high as 31-32% in the years right after the turn of the century. Now it’s more like 24%. Hmmm.   Does it really make sense that financial assets in the US trade at such a premium relative to the rest of the world? There are many reasons that there should be SOME premium, for example, the depth of US capital markets along with their transparency is one factor, though that has been the case forever. According to the website Trading Economics, the GDP of China has gone from $2.7T in 2006 to $10.9 in 2015, an increase of 4x. Over the same time frame the US has gone from 13.9 to 17.9T, an increase of 29%. But US financial assets are grabbing market share?   One might say that the discount rate in the US is so low that the present value of future earnings completely justifies the mismatch. However, US rates appear to be on the march higher. All I am doing here is questioning when, if, and how this situation resolves. 

The other thought-provoking piece I read this week was written by William White, titled ‘Ultra Easy Money: Digging the Hole Deeper?’ This is yet another ‘insider’ from the OECD, who excoriates modern central banking:

“I would contend that all the relevant policy makers were seduced into inaction [during the build up to the crisis] by a set of comforting beliefs, all of which we now see were false. Central bankers believed that, if inflation was under control, all was well. As a corollary, in the unlikely case that problems were to emerge, monetary policy could quickly clean up afterwards.” 

Paul Romer of the World Bank wrote a paper with a similar theme, “The Trouble with Macroeconomics” in which he distills the problem with current theories and models: “Assume A, assume B,…blah blah blah …and so we have proven that P is true.” The models aren’t working. The reason I mention these pieces is that the upheaval in institutional distrust has spilled heavily into central banking debates, increasing uncertainty. 

Here’s another William White excerpt, “…most importantly, a lower discount rate works primarily by bringing spending forward from the future to today. In this process, debts are accumulated which constitute claims reducing future spending. As time passes, and the future becomes the present, the weight of these claims grows ever greater.”

The above sentence is the true crux of the problem. Given excessive debt levels can Trump’s policies spur ‘pent-up’ demand? Perhaps so with respect to infrastructure spending.  A dollop of regulatory relief should also be a positive catalyst. But obstacles remain in the form of underfunded pensions and heavy student debt loads, along with record nominal corporate debt and increased government deficits. On the consumer side, consider vehicle sales. The last data shows an 18 million rate…that’s about where it was in 2006, before plunging to 10 million in 2009/10. Now we’re back at the highs; does this suggest pent up demand? Note that subprime auto lending has increased substantially. All I am saying here is that US financial market euphoria should perhaps be tempered by some real world roadblocks.

What I really want to focus on from William White’s paper is this passage relating to Emerging Market debts and attendant stresses. Here’s the quote:

 “Adding to the concern about prospective capital outflows from EME’s must be the nature of the previous inflows. Whereas in earlier years they were mostly driven by cross border bank loans, the flows in recent years have been dominated (esp in SE Asia and Latin America) by off-shore issues of EME corporate bonds purchased largely by asset mgmt. companies. Since most of these bonds have been denominated in dollars and euros in response to low interest rates, this raises the specter of currency mismatch problems of the sort seen in the South Eastern Asia crisis of 1997. The fact that many of the corporate borrowers have rather low credit ratings also raises serious concerns, as does the maturity profile. About $340B of such debt matures between 2016 and 2018.”

I think the idea of a dollar funding shortage in emerging markets could spill more forcefully into the front end of the euro$ market. As an exercise, I went back and compared the period of 1995 to 1999 (capturing the Asian Crisis) to current EM and DM currencies. There are a lot of charts, and I was struck by how similar the current formations are, as compared to the period prior to the turn of the century.  For example, $/yen chart is below. The current prices are in white, and the 1995-99 periods are in orange. $/yen on top, then DXY $ Index, EURUSD, INR India rupee, and CL Crude Oil

Whether one looks at JPY or EUR or DXY or INR (India Rupee) or even Crude Oil, patterns from 1995 to 1999 are very similar to the current 4 year period from 2012 onward. Even the crisis currencies of the Indonesian Rupiah (SE Asia of late 1997) and the Russian Ruble (with the crisis in late 1998) share similar directional biases. 

However, there were large differences. In 1996 to late 1997, the FF target was between 5.25 and 5.5%. With the LTCM and Russian Ruble crises it was cut to 4.75% in late 1998. But by the end of 1999 it was back up to 5.5% and then up to 6.5% by the middle of 2000. Recall that this was the period of the Nasdaq bubble.  

My only conclusion is that this period has many similarities to 20 years ago. The valuation of US equities relative to the rest of the world seems too high. Economic imbalances don’t appear to have been corrected; in fact, market patterns appear to be rhyming with previous crisis periods.