January 9, 2015



As we enter the New Year, the economic and market environment continues to wrestle with two opposing forces.  We are seeing deflationary pressures from the growing global debt and subdued economic growth while at the same time, inflationary pressures continue from the monetary policies of global central banks.  Let’s take a look at both.


To start, let’s see where the deflationary pressures are evident.  The chart below shows the U.S. 10-year Treasury bond yield.




The 10-year yield has dropped from around 3% a year ago to below 2% recently.


Next, here is the 10-year German Bund yield.




This drop is more significant at it has fallen from about 1.8% a year ago to about 0.45% recently.


Next, let’s look at the 10-year yield on Japanese government bonds.




This yield has dropped from around 0.70% a year ago to under 0.30% lately.


One explanation of the drop in the yields of U.S. government bonds is that money is coming into the best economy among weak established economies which is evident in the strong rise in the U.S. dollar relative to the Euro and the Yen.  And, those money flows are going into our Treasury bonds driving yields lower.  However, if that was the primary reason for the drop in yield we probably would not be seeing a collapse in the yields of the government bonds related to both of those currencies where money is leaving.


Now, let’s move to another asset class, commodities.  Here we can take a look at metals, agriculture and the latest obvious one, oil.  First, here is an ETF of industrial metals or some of the most used metals in the economy such as copper, aluminum and zinc. 




This chart shows the decline over the last 5 months, which is about a 14% drop.


While agriculture prices are more of a reflection of weather and plantings, it is still interesting to take a quick look. 




The chart above shows about a 12% drop in agriculture prices such as corn, wheat and soybeans.


Next, here is a chart that shows the collapse in oil prices.




Oil prices have dropped over 55% in the last 7 months.


Now, let’s take a look at inflation expectations as shown in a chart by BofA Merrill Lynch.



Without going into the details of this metric, you can see by the trajectory of line at the end of the chart, inflation expectations are dropping at an accelerating rate.  They are lower than at any time since the financial crisis in 2008 and at the pace of this decline, we are likely to see it break below that crash level soon.


So, what we are seeing from a deflationary standpoint is global government bond yields declining sharply, commodity prices dropping notably and inflation expectations rapidly heading toward the lows at the peak of the scare during the financial crisis.  The scare of deflation for economic and market participants is that if it starts to accelerate then purchases in the economy are delayed because purchasers believe they can get a better price the longer they wait and economic activity is then in trouble.  Personally, I don’t mind a little deflation.  However, the Federal Reserve is especially worried about deflation in this environment because they see inflation expectations dropping sharply after printing all this money and keeping rates at zero, and they know there is not a lot left in their arsenal. 


The primary drivers of the deflationary pressures are global debt and related weak economic growth.  The Geneva Report is commissioned annually by the International Centre for Monetary and Banking Studies.  The latest report takes issue with all the discussions around how debt burdens have been reduced since the economic crisis in 2008.  The report discusses how there has been a rapid rise in public sector debt among the developed countries and private sector debt in emerging countries, especially China.  It reports that total world debt has risen from 160% of national income in 2001 to 200% in 2009 at the end of the financial crisis to 215% in 2013.  The IMF put out a study reporting that global debt markets have risen from $70 trillion in 2007 to $100 trillion in 2013. 




Now, let’s turn to discuss where we are seeing inflation in the current environment.  Here, I am not talking about the rising cost of education and healthcare as I see that being an issue with the dynamics of the way those sectors are structured, funded and operate; both of which are highly dysfunctional.  Instead, it is inflationary pressures that are coming from global central bank monetary policies.  To illustrate just how extreme monetary policies have been and are going, we can look at the chart below from from googling global central bank balance sheets.




The chart above shows the combined balance sheets of our Fed, the European Central Bank, the Bank of Japan and the Bank of England in the dark green line.  Then, the average of the yields controlled by these central banks is in the dark blue line.  This illustrates just how extreme monetary policy has gone and it is going to get even more extreme.  We have never seen this in history. 


Economic theory would indicate that all of this easy money will create inflation.  Well, the inflation so far has not shown up in the real economy such as wage inflation and commodities but rather in financial asset prices; i.e., the stock market. 


The central banks have printed all this money and moved rates of return on safe assets for savers to basically nothing.  So, where do the savings stored up go?  Instead of the money going into consumption, as reflected by weak global consumption, much of it has gone into riskier financial assets.  However, the plan by the Fed to ramp up the prices of financial assets to create a wealth effect so as to encourage consumption, so far has not worked. 




The issue with investors chasing the inflation in stock prices is that it is based more on the manipulation by central banks through monetary policy, when the fundamentals are more in sync with the deflationary forces reflected in government bond yields and commodities.  If you listen to the financial media they justify stock prices rising because earnings are doing well.  But, then when asked why are global bond yields crashing along with declines in commodities which reflect economic activity such as base metals and oil, they say it is due to weak global growth and deflationary pressures.  Now, how do you get improved earnings from weak global growth and signs of deflation?


To try to reconcile this, you can look at profit margins and financial engineering.  First, let’s look at profit margins.




As you can see by the chart above, corporate profit margins are at record highs.  The chart also illustrates that margins tend to be very mean reverting and do not stay abnormally elevated or depressed for very long.  If you look at the deflationary pressures, corporate inputs from commodity prices, to wages they pay, to reductions in interest expense from low rates have all contributed to the record margins.


Also, financial engineering has dramatically contributed to earnings.  Here is a chart of corporate debt.



This chart shows that total corporate debt is 35% higher than the ‘08/’09 peak.  Once again, we see that monetary policy has encouraged corporations to take on more debt.  So, what have the corporations spent all this money on?  Capital expenditure numbers have been very muted indicating that they are not finding an abundance of attractive new investments to pursue, especially in the environment of weak global demand.  So if you can’t find new capital projects to invest in for future growth, what can you do to help with earnings?  The answer is, reduce the number of shares outstanding by buying back your own stock.  After all, earnings per share is calculated by the earnings of a company divided by the number of shares outstanding.  It is estimated by Standard and Poor’s that companies spent $565 billion this past year on buying their own stock back. 


Even with subdued revenue growth, these dynamics have helped dramatically with making current price/earnings multiples look more reasonable.  That is why it is a good time to use valuation metrics that smooth out dynamics such as unusually high profit margins coupled with a surge in corporate buybacks, such as CAPE [cyclically adjusted price earnings ratio].  These valuation metrics are significantly elevated now.


However, financial engineering of using the effects of monetary policy to issue low cost debt and fund significant increases in share buybacks doesn’t last forever.  IBM is a perfect example where eventually top line revenue growth is needed to justify stock price levels and the benefits of corporate buybacks run their course.  Caterpillar is another one to watch among many others. 




So, we have monetary policy not only encouraging investors to chase stock prices but also providing the means for corporation to issue cheap debt to fund buying back their own stock.  The longer the muted fundamentals and deflationary forces continue, the longer the extreme monetary policies will go on.  However, weak fundamentals and deflationary conditions discourage capital spending by corporations which is the fuel for future growth, and future growth is eventually required to support stock prices. 


The Fed eliminating any return on safe assets also tends to encourage investors to extend their investments further and further out the risk curve over time.  As more investors move incrementally into riskier assets to find yield and return, those yield and return opportunities are marginalized.  Investors then take the next increment of risk to generate the same return as they had before in a safer asset.  They enjoy the asset price inflation created by the Fed until they realize that the assets they now hold are not supported by the underlying fundamentals found in weak global growth and deflationary pressures.




Now, here is an interesting scenario that I have not heard discussed among financial pundits or economists.  When the Fed prints a ton of money and keeps rates at zero for very long periods of time, everyone expects inflation.  What if we really are getting the expected inflation now in the form of asset price inflation?  It is the kind of inflation investors love, at least while it lasts.  But, what if the Fed turns out to be sowing the seeds of much more dangerous global deflation by the very policies they currently believe are fighting deflation?


What is a side effect of all this easy money?  It is cheap and easy debt.  As I discussed above, global debt keeps rising at a rapid rate encouraged by all this “free” money sloshing around the world from the global central banks, and led by our Fed. 


Now, what is a primary driver of “bad” deflation?  It is deleveraging from high debt levels.  So, while the Fed believes it is fighting deflation with their policies, we get asset price inflation but deflationary pressures are still building in a number of areas of the real economy.  The wealth effect they have been looking for is not helping them address the deflationary pressures they are seeing.  We may see this Fed “medicine” turn out to be fuel for the deflation fire as the global economies have to eventually address the massive debts they are financing from Fed policies.  That will be really interesting if the global debt bell rings at a time when the global central banks have few bullets left. 




On that cheery note, let’s look at how the market continues to be battling the slowing global growth but trained to rally on the Fed.




The chart above shows the action of the S&P 500 since September.  The market started dropping in late September into mid-October.  Then, right at the lows, James Bullard of the Fed came out and said that they may not end QE like they were planning.  The market immediately started to rally through November.  Then, the market started dropping in early December until the day of the Fed meeting in which they sounded relatively dovish as far as raising interest rates and the market once again had an immediate pop.  Next, the market had its worst three days of a new year ever and what do you know, but another Fed member, Evans, came out and said that it would be a catastrophe if the Fed were to raise rates anytime soon and markets pop once again.  It seems now that anytime the market starts to look like it could have a more meaningful correction, the Fed sends out a member to talk it back up again.  It seems that the weak global growth is weighing on stock prices but the market is so conditioned to respond to the words of the Fed that we get this type of action.




Before I close for this month, it is interesting that we ended last year with one of Goldman’s sentiment indicators at its highest possible level.




This indicator is shown above and represents net positions on S&P 500 Futures contracts.  It was floored at 100 meaning investors were positioned for maximum future gains from rising stock prices.  This tends to be a contrarian indicator and what followed was the worst three day start to a new year ever, as I mentioned above.  This positioning may not have been worked down just yet.


As I close for this month, it is worth mentioning that I have seen an unusually high amount of distribution under the surface of the market since the beginning of December.  I track buying and selling pressure on a daily basis by looking at price and volume movements on the major exchanges.  If this selling pressure continues to build while stock prices are near their highs, it will likely mean corrective forces will take hold.




Also, crashes in the price of oil are usually associated with unpleasant developments in financial markets.  Here are a few comments from Jeffrey Gundlach, who is viewed as the new bond king in financial circles. 


“Something between 14% and 19% of the junk bond market is energy related.  So when you have oil prices staying where they are for several months  – which is likely because that is a policy decision that some oil producers have made – some of these companies will start to really run into financial troubles.  Now, some people are saying:  ‘That is confined to energy, it is a pocket of the economy, everything else is OK and insulated.’  But that argument usually does not work.  When the housing market started to get weak in the subprime category, even Ben Bernanke said: ‘That does not matter, it is just subprime.’  But, things are linked together.”


And for those who are banking on oil prices providing a net benefit to the economy, here is a quote from Ray Dalio, the founder of the largest and one of the most successful hedge funds in the world.


“In its November 14, 2014 Daily Observations (‘The Implications of $75 Oil for the US Economy’), the highly respected hedge fund Bridgewater Associates, LP confirmed that lower oil prices will have a negative impact on the economy.”


“After an initial transitory positive impact on GDP, Bridgewater explains that lower oil investment and production will lead to a drag on real growth of 0.5% of GDP.”


“The firm noted that over the past few years, oil production and investment have been adding about 0.5% to nominal GDP growth but that if oil levels out at $75 per barrel, this would shift to something like -0.7% over the next year, creating a material hit to income growth of 1-1.5%."


He wrote this identifying the issues with oil at $75 and it is now at $47, a full 37% lower.


With oil at $47, here is a final recent quote from Gundlach.  “Oil is incredibly important right now.  If oil falls to around $40 a barrel then I think the yield on the ten year Treasury note is going to 1%.  I hope it does not go to $40 because then something is very, very wrong with the world, not just the economy.  The geopolitical consequences could be – to put it bluntly – terrifying.”


To balance these risks voiced by Bridgewater and Gundlach, David Tepper, another highly respected investor believes that stock prices may elevate even more.  His rationale is that the European Central Bank is going to be forced to come into the market soon with significant QE, or money printing, and we get further asset price inflation since the “free” money is going into financial assets rather than the real economy.


In light of the growing cross winds, the environment should provide a very interesting year ahead for investors to navigate.  We are living in historic times with respect to monetary policy, economic repercussions and financial asset prices.  Enjoy the ride!



Joseph R. Gregory, Jr.





 Past results are not indicative of future results.  Joseph Gregory is President of Heritage Capital Partners, Inc., a registered investment advisor.  All materials presented herein are believed to be reliable but we cannot attest to its accuracy.  All material represents the opinions of Joseph Gregory.  Investment opinions or recommendations may change and readers are urged to check with their financial advisor before making any investment decisions.  Opinions expressed in these commentaries may change without prior notice.  Joseph Gregory and/or clients of Heritage Capital Partners, Inc. may or may not have investment positions that are in or aligned with any opinions mentioned in these commentaries.  There is risk of loss as well as opportunity for gain when investing in the financial markets.  Investment opinions or positions mentioned in these commentaries are not suitable for all readers and therefore, readers are urged once again to check with their financial advisors before making any investment decisions.