The Vanishing Treasury Yield

Thursday, August 2nd, 2012

by Neuberger Berman Research

July 2012 – Investment Strategy Group

Despite hitting record lows earlier in the year, the yields on U.S. Treasury bonds continue to tumble. The 10-year rate ended last month at 1.62%, materially below the long-time monthly record low of 1.95% set in January 1941. Yields for 10-year Treasury Inflation-Protected Securities (TIPS) have been persistently negative since the fourth quarter of 2011 and continue to trend lower, implying that investors are paying increasingly higher prices for the relative safety these investments are supposed to provide. In this edition of Strategic Spotlight, we consider why yields continue to decline and the implications for investors.

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A Mystery, But Is It?
Yields on long-term Treasuries have been declining since the 1980s, when they peaked along with inflation. Since the financial crisis of 2008, the continued reduction in Treasury yields has at times perplexed even the most astute investors. One prominent bond guru famously avoided them in 2010 to the detriment of his portfolio, and pundits who prematurely declared the imminent “death” of bonds couldn’t have been more wrong. In recent years, yields have moved even lower even though inflation has held fairly steady.

Over the longer term, nominal yields for long-term Treasuries generally follow inflation levels and growth expectations. When inflation rises, nominal yields typically rise to compensate for the erosion in purchasing power and, similarly, if growth expectations rise, the increase in attractive investment opportunities in the economy tends to result in rising real (after inflation) interest rates (see Figure 1). Oddly enough, inflation expectations (as implied by the difference between the nominal 10-year Treasury yield and TIPS yield) have held steady at around 2% and the decline in nominal rates has been driven mostly by declining real yields—all in the face of a positive, albeit slow, growth environment.

REAL YIELDS AND GDP TEND TO MOVE TOGETHER

Source: Factset.

So, what explains this somewhat unusual phenomenon? Since the onset of the financial crisis, bond purchases by the Federal Reserve have increased as it has implemented unconventional monetary policies, specifically quantitative easing and maturity extension programs (known to most as Operation Twist). Through these measures, which have tended to lower long-term interest rates, the Fed has sought to stimulate the economy and reduce unemployment at a time of low inflation. Another pressure on rates has come from foreign demand for Treasuries, which has generally been very strong, especially during periods of heightened market anxiety. In recent months, slowing purchases by emerging market central banks have been offset by flight-to-quality demand from European investors, who have also driven the nominal rates on certain German, Dutch and Danish bonds to negative levels. Meanwhile, U.S. investors have shown a lack of appetite for risk as flows to bond mutual funds have outpaced those into equities.

How Low Can Rates Go?

In theory, there is no bottom for bond yields. Declining inflation and continued risk aversion have historically caused nominal rates to fall. Real yields have been significantly negative in certain time periods, although admittedly when inflation was higher than today. Figure 2 shows that there have been two key periods since the 1920s in which real rates where very negative—during the Great Depression and World War II era, and in the 1970s when inflation spiked along with oil prices. Should global economies falter in the coming months, it’s possible that interest rates could move In theory, there is no bottom for bond yields. Real yields have even been significantly negative in certain time periods. lower (even turning negative on the short end), especially if the Fed engages in another round of asset purchases.

REAL RATES HAVE ‘GONE NEGATIVE’ IN THE PAST

Source: Factset.

Better Opportunities Elsewhere

It should be noted, however, that there are major risks in holding Treasuries with little to no yield. An end to the continued bull run in Treasuries would imply a reversal of some factors supporting it now, such as low inflation, deteriorating growth expectations and worsening prospects for the eurozone debt crisis. With global central banks launching unprecedented levels of monetary easing, potentially higher levels of inflation could hamstring the Fed’s ability to continue asset purchases – causing both inflation expectations and real yields to go higher. In addition, investors may realize that Treasuries might not be as “risk-free” as they assumed, particularly as the debate over the U.S. federal budget deficit intensifies later this year.

While interest rates could still move lower in the short term, we believe that the return profile for the asset class is skewed to the downside, especially given our base-case assumption of low but positive growth. We advise caution in holding excess levels of Treasuries and believe that other assets, such as high yield fixed income and high-quality U.S. equities, could be more attractive in this environment. Similar to buying tech stocks in the late 1990s with no sales and earnings, buying today’s Treasuries with minimal yields could prove hazardous for investors.

*Source: Factset

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Tags: Astute Investors, Attractive Investment Opportunities, Detriment, Financial Crisis, Growth Environment, Growth Expectations, Imminent Death, Inflation Expectations, Inflation Protected Securities, Investment Strategy, Neuberger Berman, Pundits, Purchasing Power, Record Lows, Relative Safety, Strategy Group, Treasuries, Treasury Inflation Protected Securities, Treasury Yields, U S Treasury, U S Treasury Bonds
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4 Reasons to Like China

Thursday, July 12th, 2012

Last month, in my Investment Directions monthly commentary, I predicted that we’d see further stimulus from China this yearas officials try to keep Chinese growth at a respectable rate ahead of a fall 2012 leadership transition.

And as I suggested would happen, the Chinese central bank last week announced its second surprise rate cut within a month. The action from the central bank was an acknowledgement that the world’s second largest economy is slowing. In the first quarter, China’s growth decelerated to 8.1% year over year, the slowest pace since the summer of 2009 as a slowing United States and ongoing European sovereign debt crisis took a toll on Chinese exports.

Still, despite China’s economic slowdown, I continue to hold an overweight view of Chinese equities for the following four reasons:

1.)    Valuations: Chinese stocks are selling at a significant discount to both other Asian emerging market countries and to their own history, especially when you consider that Chinese inflation is decelerating. In addition, current discounted valuations appear to be already reflecting the risk of a hard landing, which I don’t believe is the most likely scenario for China.

2.)    Growth Expectations: While China is experiencing a slowdown, it’s important to put China’s growth in perspective. I expect second quarter Chinese growth to come in around 8%, a level consistent with a soft landing scenario, and not anywhere near the United States’ truly slow 2% growth. In addition, the preponderance of evidence – and the few bright spots among weak recent economic data — still suggest that China can engineer a soft landing and even if China ends up growing at 7% to 7.5% next quarter, Chinese equities still look cheap.

3.)    Economic Policy: That China lowered interest rates twice within a month suggests that Beijing is refocusing on, and is willing to go the distance to stabilize, growth. In fact, I continue to expect more stimulus from China as it tries to ensure a smooth upcoming leadership transfer and as cooling inflation in the country gives the government more room to focus on growth. In addition, the gradual liberalization of the financial industry is also a plus for long-term growth.

4.)    Relatively Low Risk: Based on my team’s analysis, China is not one of the 15 riskiest markets. In addition, China enjoys a relatively stable currency, which reduces the volatility of its USD returns.

To be sure, Chinese equities, along with other risky assets, are still vulnerable to the fortunes of the global economy, and an exogenous shock, such as a worsening eurozone crisis, could certainly knock China off of its trajectory. But in the absence of such an event, most evidence suggests that China can engineer a soft landing and its outlook seems more positive than investors may be discounting. I prefer to access Chinese equities through the iShares MSCI China Index Fund (NYSEARCA: MCHI) and the iShares MSCI China Small Cap Index Fund (NYSEARCA: ECNS).

Source: Bloomberg

Russ Koesterich, CFA is the iShares Global Chief Investment Strategist and a regular contributor to the iShares Blog.  You can find more of his posts here.

In addition to the normal risks associated with investing, international investments may involve risk of capital loss from unfavorable fluctuation in currency values, from differences in generally accepted accounting principles or from economic or political instability in other nations. Emerging markets involve heightened risks related to the same factors as well as increased volatility and lower trading volume. Securities focusing on a single country and investments in smaller companies may be subject to higher volatility.

Tags: Acknowledgement, Chinese Central Bank, Chinese Exports, Chinese Growth, Chinese Stocks, Debt Crisis, Economic Data, economic policy, Economic Slowdown, Emerging Market Countries, First Quarter, Growth Expectations, inflation, Investment Directions, Leadership Transition, Preponderance Of Evidence, Sovereign Debt, Stimulus, Surprise Rate, Valuations
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U.S. Exports: A Lower Gear, but Still Cruising

Tuesday, July 10th, 2012

by Milton Ezrati, Lord Abbett

July 2, 2012

Exports have remained one of the few consistent bright spots in this otherwise subpar economic recovery. The growth of exports at times has added as much as two percentage points to the overall pace of the economy’s expansion and is a major reason why American manufacturing has staged a comeback in recent years—a “renaissance” some have called it. But of late, with the dollar rising against both the euro and the yen, and with growth overseas slowing or, in Europe’s case, falling, questions have arisen about the sustainability of U.S. export strength. Doubtless, the pace of gain will slow, but probabilities suggest that the growth will continue.

The American export boom actually took off in 2007, stood up remarkably well during the 2008–09 recession, and has generally picked up momentum since. As Table 1 shows, exports of goods and services jumped 13.3% in 2007 and continued to grow almost apace in 2008, even as the global financial crisis rocked world economies. Unsurprisingly, exports fell during the global recession year of 2009, but they rebounded into 2010 and 2011, despite the disappointing pace of the global expansion. Even more recently, as China has reduced its overall growth expectations and Europe has fallen into recession, export growth so far this year has actually accelerated. Because exports amount to barely 15% of all U.S. economic output, this performance, impressive as it is, could not turn a sluggish recovery into a rapid one, but it has been fast enough at times to add considerably to the pace of growth. In late 2007, net exports accounted for more than half the economy’s overall expansion. In 2010 and early 2011, they accounted for one-third of the economy’s overall growth.

The expansion of the global economy, especially the emerging world, explains some of these gains. The 2007 export jump, especially, reflected the booms in China, India, and other emerging economies that were proceeding at the time and that consumed industrial supplies and raw materials for which the U.S. economy, among others, was in a good position to provide. Of course, the global downturn in the late 2008/early 2009 helps explain the export drop averaged in 2009, but that picture quickly changed as the emerging economies resumed their rapid growth trajectories in 2010 and in the early part of 2011.

Also explaining the American export picture are the declines in the dollar’s foreign exchange rate, which cumulatively enhanced American producers’ price competitiveness. Between 2002 and 2007, for example, the euro rose about 40% against the dollar, while the yen rose more than 15%. These favorable (for exports) currency patterns continued through much of this more recent period too, further enhancing America’s competitive position. In 2007 alone, the dollar cheapened almost 10% against the euro and then rose only slightly since, at least until much more recently. The move against the yen was even more dramatic. Between mid-2007 and late 2011, the yen rose almost 40% against the dollar. Not only did the currency moves give U.S. producers inroads into the European and Japanese markets but, more significantly, they also gave a significant edge against the European and Japanese competition in faster-growing third markets, such as China, India, and Brazil.

There can be no denying, however, that the dollar’s recent gains, if they persist, will strip away some of this competitive edge. In recent weeks, for instance, the euro and the yen have each cheapened almost 5.5% against the dollar. But because previous dollar declines had given American producers such huge pricing advantages, even recent dramatic currency moves leave much of this country’s former global pricing advantage intact. According to calculations by the OECD (Organization for Economic Cooperation and Development), underlying measures of comparable pricing (what econometricians refer to as purchasing power parity), put today’s euro, at about $1.25, only just on a competitive par with dollar-based production. Comparable calculations for Japan show the yen still giving American producers a huge 35% pricing advantage against the Japan-based competition.

Though combined with slowing global growth, recent dollar strength will retard the future rates of export gain, but it should be clear that relative pricing advantages have hardly proceeded far enough to erase it. For one, trading arrangements are based on ongoing pricing and supply relationships built over long periods of time. Those that have developed in favor of American products during these past years of great American pricing advantages will take a long while to unwind. Given the American advantage implicit in the still pricey yen, it is doubtful that such a process has even begun or will begin for some time yet. If the euro is closer to competitive parity, it still offers no special pricing advantage that would prompt buyers to switch away from established American suppliers. On this basis, exports should continue to contribute to aggregate growth in the U.S. economy, albeit at a reduced rate, say, growing 8–10% rather than within the 14–17% range of the past three years.

Table 1. U.S. Exports of Goods and Services

Source: Bureau of the Census, Department of Commerce.
*Through April annualized.
+ Calculated from December through April and expressed at an annual rate.

The opinions in the preceding commentary are as of the date of publication and subject to change based on subsequent developments and may not reflect the views of the firm as a whole. This material is not intended to be legal or tax advice and is not to be relied upon as a forecast, or research or investment advice regarding a particular investment or the markets in general, nor is it intended to predict or depict performance of any investment. Investors should not assume that investments in the securities and/or sectors described were or will be profitable. This document is prepared based on information Lord Abbett deems reliable; however, Lord Abbett does not warrant the accuracy or completeness of the information. Investors should consult with a financial advisor prior to making an investment decision.

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Tags: American Export, Booms, Economi, Economic Output, Economic Recovery, Export Boom, Global Economy, Global Expansion, Global Financial Crisis, Global Recession, Growth Expectations, Lord Abbett, Milton Ezrati, Momentum, Pace, Percentage Points, Probabilities, Renaissance, Sustainability, World Economies, Yen
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Jeff Rubin: The End of Growth

Thursday, May 31st, 2012

 

 
Jeff Rubin, author of The End of Growth (his second best-selling instalment), discusses the effect and ramifications of expensive-to-produce oil, in the context of the developed world’s over-indebtness, with Pierre Daillie. He says our growth expectations, including those of Canada need to be adjusted downward, as low interest rates will not be sufficient to re-ignite growth, and the catch-22 of (high) oil prices will snooker (global economic) growth in the foreseeable future.

Rubin, former Chief Economist, CIBC World Markets, shares his current investment outlook as well.

At the heart of Rubin’s thesis is his well-informed premise that we’ve burned all the ‘cheap’ oil, and unless we learn to use less oil, growing global consumption of the black stuff can only come at growth’s expense.

Bottom line: We are destined to relinquish economic growth in return for the increasing global appetite for energy.

The End of Growth, by Jeff Rubin, is an eye-opener, an interesting and controversial perspective on the future of trending issues affecting global economic progress.

Discussion:
The End of Growth – Do You agree or disagree?

Tags: Appetite, Bottom Line, Canadian Market, Catch 22, Cheap Oil, Chief Economist, Economic Progress, Eye Opener, Foreseeable Future, Global Consumption, Global Economic Growth, Growth Expectations, Indebtness, Instalment, Investment Outlook, Jeff Rubin, Low Interest Rates, Nbsp, Oil Prices, Perspective, Premise, Ramifications, Snooker, Thesis, World Markets
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Shifting Focus: Behind Country Valuations Today

Thursday, April 5th, 2012

by Russ Koesterich, iShares

As the European financial crisis raged last fall, investors were closely monitoring metrics like credit default swaps and yields on Italian bonds to determine where to place their country bets.

But 2012 has brought some stability to the eurozone and with it we’ve noticed a shift in the types of indicators that investors should be tracking when it comes to determining country valuations — metrics that show economic growth.

Yes, investors have always kept an eye on economic growth by tracking metrics like leading indicators, retail sales and industrial production. But what Nelli Oster, an investment strategist on my team, has noticed is that over the last six months, the sensitivity of country valuations to economic growth expectations has intensified.

Perhaps six months ago investors were too consumed by worries over European solvency to focus on economic growth. But today, that appears to have changed as those worries have lessened and as economic growth has become more varied and harder to find.

Nelli’s research shows that the country valuations have become more sensitive to how the near-term growth prospects for a country compare to past trends. Take China as an example. In early March, the Chinese government modestly lowered its annual growth target to 7.5% from 8%. While that is still a very healthy pace compared to the developed world, it left investors more worried about a slowdown in China — and the MSCI China index fell 6.9% in US dollars in March.

Nelli has also found that the valuations of developed market countries have become more sensitive to absolute growth levels, or how the near-term growth projection for a developed country compares to those for other developed markets. The growth projections Nelli analyzed were garnered from leading indicators.

She also noted that there’s more variation in growth rates. Countries such as the United States, Mexico and Japan are expected to grow faster relative to their past trends than six months ago, while prospects for countries such as Italy and Belgium have deteriorated. As growth is more difficult to find, investors seem willing to pay a larger premium to access it.

For investors, the intensified emphasis on growth means that in coming months, faster growing countries will likely be rewarded with higher returns, and the difference in returns between faster growing countries and slower growing ones will likely stay elevated.

Of countries expected to fare well relative to their past growth trends – also taking into account valuations, corporate sector profitability and riskiness – I hold overweight views of Norway and Russia. Of countries expected to slow down further, I hold underweight views of Italy and India (potential iShares solutions: AMEX: ENOR, NYSEARCA: ERUS).

Sources: Bloomberg, Worldscope

Disclosure: Author is long ERUS

International investments may involve risk of capital loss from unfavorable fluctuation in currency values, from differences in generally accepted accounting principles or from economic or political instability in other nations. Emerging markets involve heightened risks related to the same factors as well as increased volatility and lower trading volume. Securities focusing on a single country may be subject to higher volatility.

Tags: China, Chinese Government, Credit Default Swaps, Developed Country, Economic Growth, ETF, ETFs, Eurozone, Growth Expectations, Growth Projection, Growth Projections, Growth Prospects, Growth Target, India, Investment Strategist, Ishares, Leading Indicators, Market Countries, Metrics, Mining, Msci China Index, Russia, Shifting Focus, Slowdown, Solvency, Valuations
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The Case for Chinese Stocks (Koesterich)

Friday, March 23rd, 2012

by Russ Koesterich, Chief Investment Strategist, iShares

China recently modestly lowered its annual growth target to 7.5% from 8%. This change has made many investors nervous that China may be in for a period of sluggish growth.

While investors are reasonably concerned about a hard landing, I believe such a scenario can be avoided in 2012. As a result, I continue to advocate overweighting Chinese equities for three reasons.

1.) Relatively Strong Growth Expectations: The lowered growth target isn’t necessarily a precursor to a hard landing. Why? The government’s 2012 growth target is a reasonable estimate for Chinese potential going forward.

The new target reflects the government’s endorsement of a beneficial, long-term rebalancing of the Chinese economy. China can’t, and probably shouldn’t, try to maintain the pace of growth achieved during the past decade as much of that growth came from fixed investments. In order to create a more sustainable long-term model, China needs to raise consumption and moderate investment, a rebalancing that will likely help support Chinese equities. Currently, China is unusual, even for an emerging market, in that only about 1/3 of its economic activity comes from personal consumption.

In addition, even if China grows at 7.5%, it still would be one of the world’s fastest growing economies and the government’s growth goal is typically a floor. In fact, actual Chinese growth is expected to be in the 8% to 8.5% range this year.

2.) Attractive Valuations: Assuming China can grow as expected in 2012 and engineer a soft landing, Chinese equities look attractive from a valuation perspective. While Chinese stocks are up significantly this year, the Chinese market is still down nearly 8% over the past 12 months. It’s now trading for less than 1.7x book value, a significant discount to where it has traded over the past five years and well below the emerging market average.

3.) The Inflation Outlook: Rising prices were a major problem in China last year, with consumer prices up 5.5% in 2011. But inflation in China is now decelerating. Currently, prices in China are up only 3.2% from a year earlier, and inflation is expected to stay low for the remainder of the year. Lower inflation will provide more latitude for the Chinese central bank to loosen monetary policy, which should further support the local economy and local stock prices.

To be sure, the Chinese market is not without risks, particularly surrounding local property prices. Still, as I expect China will most likely engineer a soft landing, the market’s decelerating inflation, cheap valuations and strong relative, and rebalancing, growth make it one investors may want to consider. For those looking to gain exposure to Chinese equities, my preferred methods of access are the iShares MSCI China Index Fund (NYSEARCA: MCHI), the iShares FTSE China 25 Index Fund (NYSEARCA: FXI) and the iShares MSCI China Small Cap Index Fund (NYSEARCA: ECNS).

Source: Bloomberg

The author is long FXI

In addition to the normal risks associated with investing, international investments may involve risk of capital loss from unfavorable fluctuation in currency values, from differences in generally accepted accounting principles or from economic or political instability in other nations. Emerging markets involve heightened risks related to the same factors as well as increased volatility and lower trading volume.  Securities focusing on a single country and investments in smaller companies may be subject to higher volatility.

Copyright © iShares

Tags: 7x, Attractive Valuations, Chief Investment Strategist, Chinese Economy, Chinese Growth, Chinese Market, Chinese Stocks, Economic Activity, Economy China, Emerging Market, Growth Expectations, Growth Goal, Growth Target, Inflation Outlook, Personal Consumption, Precursor, Rebalancing, S Endorsement, Sluggish Growth, Term Model
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Goldman Tells Clients to Short 10-yr Treasurys

Monday, January 23rd, 2012

As of a few hours ago, Goldman’s Francesco Garzarelli has officially told the firm’s clients to go ahead and short 10 Year Treasurys via March 2012 futures, with a 126-00 target. While Garzarelli is hardly Stolper (and we will have more on the latest Stolpering out in a second), the fact that Goldman is now openly buying Treasurys two days ahead of this week’s FOMC statement makes us wonder just how much of a rates positive statement will the Fed make on Wednesday at 2:15 pm. From Goldman: “Since the end of last August, we have argued that 10-yr US Treasury yields would not be able to sustain levels much below 2% in this cycle. Yields have traded in a tight range around an average 2% since September, including so far into 2012. We are now of the view that a break to the upside, to 2.25-2.50%, is likely and recommend going tactically short. Using Mar-12 futures contracts, which closed on Friday at 130-08, we would aim for a target of 126-00 and stops on a close above 132-00.” As a reminder, don’t do what Goldman says, do what it does, especially when one looks the firm’s Top 6 trades for 2012, of which 5 are losing money, and 2 have been stopped out less than a month into the year.

What is Goldman’s rationale for shorting 10 Years?

At this stage of the cycle, growth expectations are in the driver’s seat: The value of intermediate maturity government bonds can be related to expectations of future policy rates, activity growth and inflation, and a ‘risk factor’ highly correlated across the main countries. These simple relationships are captured by our Sudoku econometric framework for 10-yr maturity yields. In coming months, we expect effective overnight rates to remain close to zero in the main currency blocs (US, Japan, Euroland, and UK) and retail price inflation to hover around 1.5-2.0% – consistent with the forwards and central banks’ objectives. With policy rates and inflation ‘dormant’ at this stage of the business cycle, bond yields (and the 2-10-yr slope of the yield curve) will likely react mostly to shifts in growth expectations.

Bond valuations are already stretched relative to consensus growth expectations: Around the turn of the year, the outlook on economic activity was buffeted by cross-currents reflecting the adverse credit conditions in the Euro area on the one hand, and the upward revisions to US GDP growth on the other. Our Sudoku model, which helps us trade-off these shifts, indicates that 10-yr government bond yields are currently trading too low (to the tune of 50-75bp) when mapped against prevailing macro expectations. Taking into account the cumulative impact of the Fed’s security purchases, the degree of mis-valuation of 10-yr bonds is roughly the same across the main regions.

Bond yields are lagging the improvement in industrial activity seen since late 2011: The momentum of our Global Leading Indicator (GLI) for the industrial cycle bottomed out in the fourth quarter of 2011, although the revised series after the latest data show it steadily improving through the second half of last year. The sequential improvement has extended into this year. We observe that, since policy rates have been floored in early 2010, intermediate maturity yields have tended to lag improvements in the GLI by around 2-3 months. With central banks on hold providing ‘carry’, fixed income investors may have been wary to trade on early cyclical signals until these received validation in the early ‘hard’ data.

Real rates (and the 2-10 curve) could play catch-up with cyclical stocks: We have identified a relatively tight positive relationship between the relative performance of US cyclical stocks vs. defensives (as captured, for example, by our US Wavefront Growth equity basket), and the 2-10-yr slope of the Treasury curve. The departure from this relationship since the turn of the year is now eye-catching. Cyclical stocks have strongly outperformed the broader market, a move probably amplified by positioning, while bond yields have barely moved, underpinned by US domestic investors’ continued attraction for ‘carry’ strategies. At a closer inspection, yields out to the 5-yr maturity have continued to decline in real terms, and are now in deeply negative territory (-150bp in 2-yr and -100bp in 5-yr, near the early November lows), while 5-yr 5-yr forward rates are barely above zero. Our estimates suggest that forward rates (5-yr 5-yr forward) are now too low. Incidentally, the fact that a potential rise in yields would come from a depressed base and mostly in response to an improvement in growth prospects (which should also influence earnings growth expectations) means that a fixed income sell-off should not pose a threat to the equity market.

The FOMC statement could provide a near-term catalyst: According to a client survey by our US trading desk, around half of those polled expect the Fed announcement to ease financial conditions further, with only 12% expecting a tightening. Around two-thirds of participants believe the mid-point of the ‘central tendency’ range for the Fed funds rate at the end of 2014 will be 75bp (the forwards) or below. Finally, 72% of respondents expect the FOMC will announce a long-run neutral policy rate of less than 4%. These results are consistent with our impression that Wednesday’s announcement is now largely discounted to represent an ‘easing event’. With the data improving, treasury yields below ‘equilibrium’, current coupon 30-yr mortgage yields at all-time lows, and discussions on policy easing shifting to ways to support the improvement in the housing market more directly, such expectations may be disappointed, in our view.

Tags: Business Cycle, Central Banks, Euroland, Fomc Statement, Forwards, Futures Contracts, Garzarelli, Goldman, Government Bonds, Growth Expectations, Maturity, Overnight Rates, Price Inflation, Rationale, Risk Factor, S Francesco, Target, Tight Range, Treasurys, Us Treasury Yields
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Bob Janjuah: The 6 Biggest Questions for 2012, Answered

Monday, December 19th, 2011

As Bob Janjuah, of Nomura, notes in his final dissertation of the year, our in-boxes are stuffed with all the good cheer of sell-side research outlooks. However, the bearded bear manages to cut through all the nuance to get to the six questions that need to be addressed in order to see your way successfully in 2012. With the US two-thirds of the way through the post-crisis workout phase while Europe remains only half-way through, and China a mere one-third through the necessary adjustments to less global imbalance, he is not a global uber-bear on every asset class as the net effect is modest global underlying demand and plenty of savings sloshing around looking for a home. The market will have to adjust further to an extended period of weakness in Europe, which will impact EM growth expectations and so the existential ursine strategist is skewing his macro expectations to the downside and with the market pricing a ‘softish’ global landing, there remains a considerable gap between downside risk potential and current expectations. Furthermore, Janjuah believes the upside is relatively self-limiting on the basis of commodity price pressures and the potential for property or asset bubble bursts – leaving upside limited and downside substantial.

Q1: Where are we in the post-crisis work-out?

The US economy is proceeding with its excess capital stock work-off when measured against either the labour force or GDP. It still looks to us like it will take another 12-18 months for the excess capital to be cleared. During this phase it remains a truism that aggregate net investment will remain modest, corporate cash holdings remain high, and that the private sector will still generate higher savings than investment. It is still unclear if the “clearing” level of the capital stock has actually fallen owing to changes in banking and financial regulation. Nevertheless, that backdrop remains supportive of quality non-financial credit, low real yields and weak aggregate equity performance. It’s worth noting that high private sector net saving should be offset by high government sector dissaving during this phase. The US policy mix, while generating a lot of angst, has allowed the US to hold things steady while this background adjustment occurs. Note: demand management policies are not able to generate a return to pre-crisis growth rates until the supply-side work-out is complete; hence the sequential aborted risk market take-offs.

The problem now is that parts of the euro area are in a very similar position but are being forced to adopt what we consider inappropriate policies from a macro point of view. Spain is a good example: who would doubt that the capital stock is some way above the long-run suitable level? As such, Spain and others are likely face only modest private sector demand for several years. A policy of fiscal tightening will only serve to increase the national saving/investment balance as the current account moves into surplus and international debt is paid down. We see this as a good thing but still think gradualism would be better than cold turkey. The added complexity is that the “clearing” level in the euro area is no longer well defined: a combination of rapid banking reform, Basle 2.5/3 and major uncertainty about supply-side and macro policy makes for an open-ended period of capex spending falls.

The final point on background work-out is about EM. China has built a lot of infrastructure since 2008 and we would argue is running some way ahead of the current warranted level. Capital deepening in EM is a good thing, but a period of modest capex looks more likely than a continuation of hyper capex growth. We don’t know as a market whether that will be sufficient to trigger non-linear balance sheet effects and a Chinese credit crunch, but certainly think Mr Market will have to romance the idea in the next 12 months.

Our conclusion is that we are two-thirds of the way through the adjustment in the US, half way through in the euro area (but without knowing the clearing level it’s impossible to be too precise) and one-third through in places like China. Net effect is modest global underlying demand and plenty of savings sloshing around looking for a home.

Q2: Where are we in the business cycle?

Clearly, while this period of work-out is going on, the global economy and its markets are particularly vulnerable to new shocks given current policy settings and the state of weaker paticipants’ balance sheets. For a while now we have been talking about an EM slowdown and hard defaults in the euro area. Both risks are now centre stage for investors.

Two themes emerge from a detailed reading of our economics team’s year-ahead forecasts. First, that the global economy is slowing, led as much by domestic demand in emerging economies as the outlook for the euro area. Fiscal drag, the echo of higher commodity prices and tighter EM policy combined with banking sector deleveraging, has led our economics team to move its forecasts toward weak H1 2012 growth before a reasonably robust recovery in H2 2012. Naturally, this would lead one to be overweight rates and underweight risk now.

But the second overarching theme that emerges is one of contingent risk. Almost every country forecast highlights the evolution of the euro-area economy as the key foreseen risk. And importantly, the gap between the muddle-through shallow recession scenario and full-blown hard landing and cost of capital shock is substantial in the simulation runs provided not just for the euro area but for all economies. Our house opinion is that the euro area does not matter a great deal to global fundamentals, until it matters a great deal. This is classic non-linear gap risk.

One area that is useful to think about is how deleveraging in the euro area will play out in terms of the aggregate data and the euro area’s surplus. It seems to us that a cross-border deleveraging against the backdrop of high multinational corporate cash balances and modest funding requirements should primarily play out through the banking sector seeing a substantial and persistent jump in its funding costs in the current account deficit economies. And it is through this channel that the economy should be influenced via the household and SME sectors seeing a sequential tightening of credit availability and increased funding costs. Naturally if I have 100 large corporates that make up my equity market and I hit their funding costs I would expect a rapid impact. But if I have 5 million SMEs and 30 million households not all of them are looking to refinance at the same time and so I would expect a staggered impact on their effective cost of capital (it’s a bit like duration considerations for governments). Confidence and market pricing of course will not respond slowly.

Another consideration that hasn’t been given much air time is the supply-side flexibility of the euro area in comparison with other major economies. We can get a handle on this issue by comparing how long it takes for changes in growth to have their maximum impact on unemployment and in turn unemployment on inflation. The results are shown in Figure 3, with the maximum lag shown in months. The basic message is that taken over the past 20 years a movement in growth has taken six months to have its maximum impact on unemployment in the euro area and in turn it takes around 16 months for changes in unemployment to have their maximum impact on inflation. It therefore takes over two years for a growth shock to have its maximum impact on inflation, working via the labour and product markets. To put this in context, the US gets there in nine months, while the UK has fairly rapid labour market reactions but relatively slow wage/inflation reactions to unemployment.

What does this mean practically? The policy framework the euro area has adopted excludes high growth or high inflation as a way out of its debt/excess capital stock burden. Instead, we are moving toward a competitive realignment via supply-side adjustment. This is where the “sacrifice ratio” comes in – simply the output loss required to generate a 1% fall in inflation. The sacrifice ratio in the euro area is still higher than in the US and UK, and is particularly high in the periphery (not Ireland, though). Thus, if Spain et al are to compete their way into growth they will face a larger increase in unemployment than others before economic growth returns. Leaving aside the policy and political implications of this, the growth implications are clear – it should be weaker than that of other countries faced with a similar problem. Once the euro area starts adjusting its supply-it exhibits a super-tanker-style turning circle. In this scenario the euro area would shift into a current account surplus – another source of excess savings to the world.

Tags: asset class, Backdrop, Capital Stock, Commodity Price, Dissertation, Downside Risk, good cheer, Growth Expectations, Labour Force, Necessary Adjustments, Nomura, Nuance, Outlooks, Price Pressures, Q1, Stock Work, Strategist, Truism, Ursine, Workout
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Vanguard’s Davis: What We Expect for Market Returns (Morningstar)

Tuesday, October 25th, 2011

Vanguard’s Davis: What We Expect for Market Returns

Even given muddled economic growth expectations in the developed world, longer-term expected returns for stocks are not outside of historical norms.

Christine Benz: Hi. I’m Christine Benz for Morningstar.com.

I recently sat down with Joe Davis, chief economist for the Vanguard Group. He discussed his market outlook as well as his views on the economy.

Joe, thank you so much for being here.

Joe Davis: Thank you Christine, pleasure.

Benz: You look at various asset classes and attempt to come up with forecasts for what they might return in the years ahead, and I understand that you’ve recently taken a look at U.S. equities in particular and ratcheted down your expectations a bit. Let’s talk about, first how you arrive at those forecasts, and second, what you’re thinking in terms of returns from the major asset classes?

Davis: So, in terms of how we approach the problem here at Vanguard, [we're] very interested in looking at what is a reasonable set or distribution of returns for various asset classes that you mentioned. Again, a key point of distinction is, we are really focusing on a distribution. It is not a point or one number. But when we would look at that, one of the key drivers for equities over long periods of time, we tend to really focus on 10, 20, 30-year horizons, because that’s where there is modest predictability, and when we look at those horizons, valuation metrics–P/E ratios, price-to-book, other measures–are a key figure in that.

So, over the course of the past year or two, some of those longer-term expectations have come down at the margin, but they are still, more likely than not, closer to history, the 1926-on expected return for equities, as a central tendency, which can seem somewhat counterintuitive, when we hear and which I think is reasonable, somewhat lower muddled economic growth in the developed world going forward. And again, a key point that we tell investors is, much more important for long-term investing is not the economic growth per se of what is expected. Much more important is the price one pays for growth. And just to push the analogy, if it was only growth that mattered then say growth stocks would always outperform value stocks and that certainly hasn’t been the case over long periods of time.

Benz: Right, right. So, with today as a starting point and looking at valuations, what sort of range of returns might be realistic for investors to look around?

Davis: So I think our range of returns, I mean, it depends how much confident one wants to be in terms of making sure if one is in that range, to a be 100% confident, you have a huge range.

When we are talking about 25th to 75th percentile, it’s something in the 4% to 12% range, which is still wide, but you know there is this natural question of lower fixed-income yields, so hence lower expected returns, greater volatility that we’ve seen recently in the markets. So, the natural question is, is the asset allocation problem, is it different in some meaningful way?

I think we can talk about some of the shifts in the expected return frontier, but the fundamental properties of strategic asset allocation, in our mind, have not changed–which means what? For a more conservative portfolio, perhaps move into more aggressive, higher-expected risk, higher-expected return.

So, I think it’s that trade-off that we have always had to grapple with as investors, and that’s still inherent and expected going forward. So, I think, broadly speaking, we’ve taken a step back, how we approach the strategic asset allocation problem is unchanged for the foreseeable future.

Benz: Now, is there any nuance in terms of your analysis among sub-asset classes, so international versus U.S. for example?

Davis: So we will look at expected ranges of expected returns for U.S., other developed markets, and then emerging markets. And then on a strategic basis, although those central tendencies can move around from month to month at the margin, there is really no meaningful expected return difference between U.S. markets and other developed markets.

There is a slight expected return differential at the margin for emerging markets, but again, that is in part because they anticipate higher volatility of an emerging market portfolio. So, there would be some expectation for compensation for that, but I wouldn’t call the differences in the central tendencies as economically or statistically meaningful.

Benz: Okay. So, for fixed income, do you use current yields as sort of a proxy for what investors might expect from bonds in the future?

Davis: We do. Again, critical to our analysis is that initial conditions do matter, and for fixed income they are critical as you mentioned, Christine. And we do look at what potential evolution of the yield curve is, as well as corporate spreads and other risk factors in the bond market. But when you look at that, a yield-to-maturity on a bond portfolio still remains to this day, all math aside, or all tools aside, it’s a reasonable return expectation, central tendency for a bond portfolio. So, I don’t think there is any getting around some of the bond math that we have lower expected returns given the fact that returns have been so stellar over the past two, three years.

Benz: And driven by declining rates, too.

Davis: Declining rates. But again I think this one from a thematic approach. I think in terms of investors, what we’re going to continue to hear are questions around or just conversations going around, where do I go for income? Is it still bonds? Yes, answers both fronts, but the return stream is just going to be lower. It could be more volatile at times, too, but I think this conversation around dividend yield paying stocks versus fixed income probably will be more accentuated today and in the next two years than it has been probably over the past decade.

Benz: So, another thing I want to touch on Joe: you and your team did some research where you looked at the performance of a balanced portfolio during varying economic conditions, both recessionary and more expansionary, and I’d like you to tell us what you found, because I do think it’s pretty counterintuitive?

Davis: So, what we found is that on average, the return on a balanced portfolio, whether adjusted for inflation or not, has been effectively similar or almost identical between periods of recession and expansion. As we all know, the U.S. economy has been one or the other. And again that does seem very counterintuitive. Part of that is because during recessions, what happens in a balanced portfolio? More often than not, there is a flight-to-quality effect for bonds, which can help offset the initial loses in equities.

The second effect, which is what I would call a leading indicator effect, the equity market is being one of those leading indicators, tends to fall, perhaps even into bear market territory long before it’s officially recognized as a recession, and then by extension and by definition tends to rebound long before the recession is officially over, and this happened as recently as early 2009, several months before the recession officially ended.

So, I think again, to my mind and our minds at Vanguard, it’s the testament to broader diversified long-term perspective–it’s not that one would wish that recessions occurs or that we’re indifferent as citizens that a recession occurs, but it’s much more of why staying the course and having a balanced long-term perspective is critical. And I think this is just a great Exhibit A of why not paying over-attention on near-term economic events can serve investors well.

Benz: For people right now, then, looking at, what seems to be perhaps a flat-lining economy, it seems that from this research people shouldn’t be overly concerned or inclined to be overly defensive at this juncture?

Davis: I would totally agree with this point, Christine, but as you mentioned, that could seem very counterintuitive, and that’s I think understandable given the information that we just have to digest. I think that when you take a step back, you said very little if any growth. We have similar expectations in the near term. Now where are those expectations coming from? We have found it most useful to look at what the financial markets themselves–the bond market, the stock market–what are the economic growth scenarios that those markets are pricing in? And it’s by those measures that give us some of these estimates of what a recession are.

So, it’s a key point to keep in mind. So in other words, the market is already pricing in, so to speak, at a high level, very little or close to zero growth, which means then to react to, if one hears, we’re going to recession, have near-zero growth, I think then to react to one’s portfolio is again we would have to keep in mind that you are reacting to the very markets themselves, to adjust to those markets, that’s something that one wants to just think twice about before one proceeds.

Benz: You may be late with that.

Davis: Yes, late.

Benz: Thank you so much, Joe. This is really helpful research. I appreciate you sharing with us.

Davis: Thank you, Christine. My pleasure.

Source / Copyright © Morningstar, Inc.

Tags: Asset Classes, Bonds, Central Tendency, Chief Economist, Christine Benz, Distinction, Economic Growth, Growth Expectations, Horizons, Joe Davis, Key Point, Long Periods Of Time, Market Outlook, Metrics, Morningstar, Norms, Outlook, Pleasure, Predictability, Ratios, S Davis, Vanguard Group
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Citi Downgrades Global Growth And Expects EFSF ‘Grand Plan’ Disappointment

Thursday, September 29th, 2011

Citi’s Economics team downgraded global growth expectations once again, expecting 3.0% this year (versus 4.0% last year) with more aggressive downgrades next year to only 2.9% (from 3.2% expectations last month and 3.7% two months ago). Growth revisions were downgraded for every major global economy as expectations move with Goldman’s coincidentally-timed discussion of stagnation (also tonight) with advanced economies cut more than developed though Eastern Europe saw the most significant reductions. They note that ‘the recent pace of GDP forecast downgrades is among the greatest of the last ten years’ and extends the recent run of lower forecasts to four months-in-a-row. In a secondary note, Willem Buiter and team also pour cold water on market expectations for the EFSF pointing out, as we have done for a few weeks now at every suggestion, that all the different options have their shortcomings and are unlikely to be implemented quickly.

From Citi’s September 2011 Global Economic Outlook and Strategy:

Global growth prospects continue to deteriorate quickly, both for advanced economies and emerging markets.

 

This month, we are again cutting our 2011-12 GDP growth forecasts for many countries, including the Euro Area, UK, Japan, US and Canada, with a modest downgrade for China and sharper cuts for Eastern Europe, Singapore, Hong Kong and South Africa.

 

 

We expect early sovereign debt restructuring in the Euro Area, and for the Euro Area overall to slip back into recession in coming quarters. The following table outlines progress so far on the initial increase:

 

 

Against this backdrop, Citi’s Macro Strategy team are cautious on risk
assets and bullish core fixed income. Citi equity strategists believe
that markets are oversold, but that stock prices are unlikely to move
convincingly higher until there are clearer signs of stability in
economic activity and profits growth. Citi rate strategists expect lower
yields and flatter curves in core EMU markets and the UK. Citi FX
strategists expect the USD and JPY to gain.

Source: Citi

Tags: Buiter, Canadian Market, Downgrades, Economics Team, Efsf, Gdp Forecast, GDP Growth, Global Economic Outlook, Global Economy, Global Growth, Gold, Growth Expectations, Growth Forecasts, Growth Prospects, Initial Increase, Market Expectations, Outlook, Singapore Hong Kong, Sovereign Debt Restructuring, Stock Prices, Strategists, Strategy Team, Table Outlines
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