The worst place to invest, except for all the others
If Winston Churchill were alive (and managing money) today he might say “the United States is the worst place to invest, except for all the others.” The U.S. economy is experiencing a historically-low growth recovery, owing largely to a polarized and gridlocked government. Equities are at the expensive end of their historic range while the denominator in the value equation, corporate earnings, is deteriorating. Government bonds are trading at record-low yields, with riskier corporate and structured credits offering returns usually associated with safe-haven assets. However, all the adverse conditions making U.S. investors anxious are present to an even greater degree around the world.
Just as the U.S. economy looked to be turning a corner in May, and speculation intensifying about a summer rate hike, markets were jolted out their sense of complacency by last Friday’s bombshell jobs report. The 36,000 non-farm jobs created were the fewest in more than six years. Given a week to further digest the news, global investors didn’t return to a state of blissful zen, stampeding out of risk assets and back into safe havens.
On Thursday, an auction of 30-year U.S. treasury debt saw near-record demand from foreign buyers at the lowest interest rates in nearly 18 months. The 2.461% yield may seem paltry for a 30 year commitment, but in the land of the blind, the one-eyed man is king. German, Japanese and Swiss 30-year bonds are now trading at historically-low yields of 0.59%, 0.28% and 0.07%, respectively. For the latter two, 10-year yields are negative, while a third straight week of gains for German bunds saw the 10-year yield fall to 0.02%.
Yields are also falling precipitously in the global corporate bond market, with Toyota this week selling $186 million worth of yen bonds at the record-low yield of 0.001%. Eurozone corporate bond yields also fell to lowest levels in more than a year as the European Central Bank (ECB)kicked off its controversial program of corporate-bond purchases.
The attraction to cash-flow generative assets isn’t limited to treasuries. After a brief lull in demand from mid-February to early March, investors are now rushing back into municipal bonds. While so far this year $40 billion has been pulled from equity vehicles, investors have poured $22.5 billion into municipal bond funds, the asset class’s best start to a year since 2009. The heavy municipal flows are occurring despite selective woes for the sector. The U.S. government is finalizing a debt restructuring plan for debt-strangled Puerto Rico and exasperated BlackRock is calling fir Illinois to be banned from raising further money in the municipal market until it gets its act together.
Mutual funds are also scrambling to buy corporate bonds, causing credit spreads to narrow again after a technically-driven widening in the first quarter. Money managers’ allocations to corporate bonds reached a fresh all-time high last week of 36.3% of portfolios, according to Stone McCarthy.
As the Fed moved to start tightening monetary policy last year, pundits also warned about the risk of dislocations in value-oriented sectors of equity markets that had benefited disproportionately from the Fed’s zero interest rate policy (ZIRP). However, with rates hardly budging from lows, investors have continued to flock into safe-haven, dividend-yielding sectors. The 24% one-year return for utility stocks (XLU) nearly doublies returns of the second-place sector, consumer staples (XLP).
Gold has also spiked to three-month highs, setting its sights on its most recent pivot top from late-April.
Janus’ Bill Gross called the preponderance of negative interest rate bonds akin to a “supernova that will explode one day.” Carlyle Group’s Jason Thomas believes low and negative interest rates have actually had the perverse consequence of discouraging business investment because they more directly incentivize companies to buy back shares and raise dividends.
While the global economy may not be as volatile as the financial markets it underpins, a new study released this week by Hyun Song Shin, head of research at the Bank for International Settlements, found that, “Financial markets, for their part, appear to be tethered more closely than ever to global events, and the real economy appears to dance to the tune of global financial developments, rather than the other way round.”
With the global economy staring into the deflationary abyss and investors taking on significant duration risk in credit markets, every single data point has the potential to completely flip the narrative. A better-than-expected U.S. jobs report next month could put a July rate hike back on the table, but for now the Fed looks increasingly likely to hold off until at least late in the year. And maybe that’s not such a bad thing. The Fed has essentially “boxed itself in: by simply preparing to raise rates, the Fed triggers conditions that make it impossible to follow through.”
Central bankers are always examining trade-offs between raising rates too early or missing the window altogether. Given the rising odds of a “Brexit,” which could further destabilize afragile eurozone economy, it wouldn’t be surprising for the Fed to happily miss its boat in 2016.
China’s good, bad and ugly
Speaking of reasons Janet Yellen and Co. may want to hold off on further rate increases, this week Chinese and U.S. officials gathered for their eighth annual Strategic and Economic Dialogue (S&ED). Prior the last week’s jobs report, a cavalcade of Fed governors began priming the market for a summer rate hike. The hawkish rhetoric surprised markets, boosting the dollar higher and making China’s currency peg a more expensive proposition. In response, Chinese officials have increasingly pushed the Fed to be more forthcoming about its monetary policy intentions.
The Chinese government is hoping greater coordination with the U.S. will allow for a smoother transition in reducing excess capacity and debt without destabilizing markets. Deflationary pressures did ease slightly in May, with producer prices falling less-than-expected (2.8% actual vs. 3.2% estimate) — the smallest decline since late 2014.
Perhaps fearful of the next U.S. Presidential administration, Chinese President Xi Jinxing alsourged the two sides to ratify an investment treaty ASAP. The communist government is embracing closer economic cooperation with the West, giving qualified U.S. investors a 250 billion yuan ($38 billion) quota to invest in China’s capital markets through its renminbi qualified foreign institutional investor (RQFII) scheme. It was the second-largest quota ever offered to a jurisdiction. While $38 billion is unlikely to make a splash, the move is thought to be a symbolic peace offering as the Fed ponders its monetary policy agenda for the rest of the year. Perhaps a more meaningful gift to would be the cessation of economic warfare in the global raw materials market.
Now for the bad news. Goldman Sachs this week said China’s debt load could be much higher than previously thought. Goldman, like many others, is particularly concerned about the increase in opaque loans and circular financing schemes, whereby banks lend to non-bank financial institutions (NBFIs) instead of directly to companies. The tangled web of financing increases risks of a systemic financial crisis.
A new report by Fathom Consulting also suggests the actual unemployment rate in China could be closer to 13%, more than triple the officially-reported figure. Fathom had previously estimated economic growth in China to be 2%, rather than the reported 6.9%.
An estimated 90% of Bitcoin trading volume is thought to take place on Chinese exchanges Huobi and OKCoin. The crypto-currency’s recent rise could just be evidence of an increasing push by investors to evade the government’s capital controls.
No sleep for Saudi Arabia
Saudi Arabia continues to move forward with its ambitious reform plan, cutting oil prices in Europe after OPEC failed to set a collective production cap last week. The price cut is the latest escalation of its economic war with geopolitical nemesis Iran, now standing as the only obstacle in the way of an agreement to ease the global oversupply of oil. Crude closed about $50 this week for the first time in nearly a year before retreating Friday.
Hardly a week goes by without Saudi Arabia releasing a new chapter in its McKinsey-created “Saudi Vision 2030” reform plan. This week Saudi officials announced new steps to increase non-oil revenue in what is being called the National Transformation Plan (NTP). In addition to embarking on a five-year process of reducing bloated public-sector salaries, the kingdom plans to invest 270 billion riyals ($70 billion) to create 450,000 new jobs. Further government revenue is expected to be raised from a new value-added tax (VAT), “sin” taxes and income tax on foreign residents.
Anticipation also continues to build for the cornerstone of Saudi Vision 2030, a partial IPO of state-owned oil company Aramco, which is worth an estimated $2–3 trillion. Global banks are lining up to participate in an offering that could generate $1 billion in fees for Wall Street.
In other news…
There is no such thing as a formula to explain why markets do what they do all the time.
The end of the U.S. manufacturing renaissance (if there even was one).
The Wall Street golden boy who allegedly fleeced his friends and family.
How HBO’s “Silicon Valley” nails the real Silicon Valley.
Life lessons from the financier known as ‘Chuck.’
Beware of guru worship — George Soros edition.
Scandals in new Brazil government offer Rousseff hope of survival.