Yields Drop but Repo Rates Leap - CIO Insights Q3 2019

Current Environment

The third quarter of 2019 produced more of the recent up-and-down pattern in the stock market, with a new peak level achieved in the S&P 500 late in July before a sharp sell-off in early August as trade war rhetoric escalated again and growth slowed in major economies, notably Germany and China. This was followed by a choppy progression through August before stocks recovered strongly in early September, almost returning to the peak level. The net effect for the full quarter was a slight increase in the stock market but variability has significantly exceeded the trend. As we can see from the following chart, the stock market has been volatile and range-bound over the past six months. New peaks were attained but seemed fragile, with declines quick to follow on any bad news. On the other hand, once the stock market fell materially (say to around 2800 for the S&P 500 index), then investors received reassurance from the Federal Open Market Committee’s (FOMC) dovish statements and/or a cooling of trade war tweets to a more conciliatory tone, encouraging a recovery in stock prices. In the background, the fundamentals for stocks have not changed much. Earnings have declined very slightly quarter-over-quarter for the past two quarters, but still show slight positive growth year-over-year. There is no particular signal yet for strengthening or weakening in overall earnings, although business activity has slowed amid trade uncertainty. In the absence of a clear picture on fundamentals, short term reactions to trade and monetary policy pronouncements have dominated investor behavior.

In the absence of a clear picture on fundamentals, short-term reactions to trade and monetary policy pronouncements have dominated investor behavior.

If the stock market at the end of the third quarter was not much different from the start of quarter, then the bond market had a quite different experience as it moved to a substantially higher level over the quarter. The US 10-year Treasury yield started the quarter at 2.04% but fell as low as 1.46% in late August and early September before recovering somewhat, starting October at 1.64% and then dropping briefly again in early October before increasing modestly as October progressed (FactSet.) Yields move inversely to prices. This also brought further yield curve inversion, as discussed in prior newsletters, which historically has predicted recession within the following 18 months. Although the drop in bond yields was partly influenced by a flight-to-safety as the trade war escalated in August, the following chart suggests that most of the influence came from the wider global bond market. As more and more foreign sovereign bonds, especially in Europe and Japan, provided a negative yield, foreign capital migrated into the US bond market in pursuit of higher yields, which drove up US bond prices and therefore drove down the yields. At the peak, there was approximately $17 trillion of sovereign bonds globally with negative yields as investors anticipated further quantitative easing from the outgoing Mario Draghi at the European Central Bank (ECB) in the face of a slowing economy in Germany, despite dissent within the ECB. The FOMC cut the Fed Funds rate by 0.25% at both the July and September meetings but, as we warned in last quarter’s newsletter, that is a slower pace of cuts than had been expected when the stock market ascended rapidly in the first and second quarter.

While lower yields on government bond yields was the primary story from the bond market, an unexpected rise in yields elsewhere also raised some concern: the overnight repo rate spiked in mid September, and FOMC intervention was required throughout the rest of the month to inject liquidity. While low yields for government bonds generally indicate pessimism about economic growth and inflation, a spike in overnight repo rates points to a tightening of liquidity available in short term financing. In simple terms, banks became reluctant to lend out their cash reserves on an overnight basis, even with Treasury bonds offered as collateral. It is unlikely that this foretells a liquidity crisis similar to Global Financial Crisis, when we heard daily about spikes in LIBOR and the TED spread, but it does indicate an imbalance as FOMC reserves have shrunk in the past year while banks need to maintain more stringent reserves than in the past; also primary dealers have seen their balance sheets expand as they purchase the increasing issuance of US government bonds and must hold reserves against these. For now, we expect the Fed to provide liquidity explicitly to the repo market and revisit the question of what size of FOMC reserves and bank reserves are appropriate for a new equilibrium, and how to balance the interest on reserves accordingly.

In the background to all of this, economic fundamentals remain on the same path as described in recent newsletters: global economic growth is slowing, although the US remains relatively stronger than most developed economies. Manufacturing PMI surveys have dipped into contraction territory (below 50) for several months, initially led by export-driven economies like Germany and Japan, who saw reduced exports to a slowing China. But even the US had contractionary scores from the manufacturing PMI survey in August (49.1) and September (47.8). And lately the service PMI surveys have followed downward too, increasing anxiety that the manufacturing slowdown is bleeding into other sectors.

At the peak, there was approximately $17 trillion of sovereign bonds globally with negative yields

A US recession does not look imminent so long as consumer spending remains robust, aided by a tight labor market, but the level of growth has been softening and increased discussion of recession risks can become a self-fulfilling prophecy if it causes widespread caution and thrift. It remains to be seen how much of this slowing is due to uncertainty around the trade war – and therefore possible to improve quickly – versus longer term slowing due to demographics in developed economies and China’s transition to a consumer-led economy. As discussed in last quarter’s newsletter, there is a growing consensus that renewed monetary stimulus is unlikely to have a major impact, and so focus is turning instead to the topic of fiscal stimulus, even in fiscally conservative countries like Germany.

Longer-Term Outlook

In the prior section we mentioned the slowing of growth in China as it attempts to mature and transition toward a consumer-led economy, which in turn has weighed on the export-driven economies like Germany and Japan, who have previously benefited from China’s importing of capital goods. This is not just some short-term situation or a cyclical effect that might rebound soon back to prior levels. There is a shifting balance among the major economies of the world that has been going on for more than two decades as China has emerged into the global economy. The following table shows the various components of 2018 GDP in each of these major economies. Even a quick glance will tell us that the US economy is dominated by consumer spending and has the lowest exposure to trade with external partners, while being the largest net importer. By contrast, China’s economy relies very heavily on investment in capital stock, e.g. roads, bridges, airports, railroads, factories, schools, hospitals, houses, etc. This reliance on investment for economic growth eventually becomes unsustainable because it requires debt to grow larger and larger relative to GDP just to preserve the same rate of GDP growth, and because there are fewer productive investment opportunities remaining. This is exactly the tension China is facing as it tries to deemphasize investment’s share of GDP and replace it with a greater contribution from consumer spending before the total debt burden becomes unaffordable. We can also see at a glance that Germany relies very heavily on exports, which means they have benefited from being part of a European free-trade union and currency union, as well as having China available as a large buyer for capital goods while China was investing heavily in capital stock. Japan was heavily dependent on investment during the post-war reconstruction (as was Germany at that time) – similar to China now – and then Japan also went through a phase of very high exports in the 1970s-1980s – similar to Germany now – but gradually Japan matured to a more balanced mix, even if they are still relatively reliant on exports to offset their need to import many resources that are beyond domestic capacity, e.g. oil, steel, food, etc. Along the way, Japan incurred the type of unsustainable debt accumulation that China wishes to avoid, and it has weighed heavily on Japanese economic growth ever since.

From these dynamics, we can infer a pattern that must play out. China cannot continue to have investment as such a large proportion of their economy, even as it is projected to gradually over take the US to become the world’s largest economy. The debt accumulation involved would not be sustainable. If China’s investment activity must slow, then the export economies must prepare for less Chinese demand for their capital goods, especially the heavy capital goods from Germany and Japan like heavy machinery for factories, transportation and construction. China’s search for a “soft landing” to transition to a consumer-led economy before the debt load becomes overwhelming (avoiding Japan’s experience), means that the exportdriven economies must find new customers – e.g. India and Africa could represent markets as large as China, but may not be ready to jump to that rate of development – or else prepare for their own deceleration from the recent level of growth.

From these dynamics, we can infer a pattern that must play out.

The US is somewhat insulated from these dynamics because so much of the economy is endogenous, but decades of moving manufacturing to lower cost countries – either through off shoring or else imports replacing domestically produced goods – like Mexico, Taiwan, then China and recently Vietnam leaves the US, as a significant net importer, with a short-term dependence on global supply chains that may be reshaped if a new geopolitical landscape of regional hegemonies takes shape as China becomes an economic superpower.

Current Positioning

During the third quarter, our view on equity moved from neutral to slightly negative once a new peak was achieved. From that level, there appears to be an asymmetry where downside potential is greater than upside over the next year or two. Within equity, we continued our preference for US large cap stocks relative to small cap stocks and non- US developed stocks, although we finally closed out our relative overweight to US large cap stocks in September, having already captured a large relative outperformance from that positioning over the past year. Emerging market stocks continue to offer a relatively attractive valuation for a longer-term holding period, primarily from their weaker currencies, but they do represent a downside risk in the shorter term. This is still an environment where most market participants are reacting to any new information or indications, and trend is difficult to discern.

We continue to hold a positive view of diversifying1 asset classes like real estate and liquid alternatives, ahead of possible further volatility in stocks, and while bond yields are already very low. But we have moved to underweight return-seeking credit – e.g. high yield bonds, bank loans and emerging market debt – as their yields have dropped to offer limited further upside relative to their risk, even if defaults and downgrades remain relatively benign. We are still overweight REITs relative to core real estate, and that tilt has performed very well throughout 2019, but we are working to shift toward core real estate before convergence between the two reverses that relative gain. Capital moves slowly into that sector.

As to bond positioning, we moved underweight duration when the US 10-year Treasury yield fell below 1.50%.

As to bond positioning, we moved underweight duration when the US 10-year Treasury yield fell below 1.50%. We trimmed half of that underweight once that yield rose back as high as 1.90% but then lost momentum and started to regress. US yields will probably continue to be volatile as global bond investors wrestle with negative yield environments in Europe and Japan, but when nominal US yields fall far below fundamentals, e.g. negative long term real yields, and the bond buying looks like an overcrowded short-term behavior, then we are willing to take a relative tilt in anticipation of some mean reversion.


1 Diversification does not ensure a profit nor does it protect against loss of principal. Diversification among investment options and asset classes may help to reduce overall volatility.


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