July 16, 2021
By Steve Blumenthal
“In highly indebted economies, additional debt triggers
the law of diminishing returns.”
– Dr. Lacy Hunt,
Economist and Executive Vice President of Hoisington Investment Management
Inflation, deflation––where are we heading? There has been no better authority over the last 30 years than Lacy. Once a quarter, Lacy Hunt and his partner Van Hoisington publish their “Review and Outlook” letter.
Is inflation temporary? Lacy says yes. Other big names are saying, “Not so fast.”
Last week, Jamie Dimon, chairman and CEO of JPMorgan, commented, “The inflation could be worse than people think. I think it’ll be a little bit worse than what the Fed thinks. I don’t think it’s only temporary.”
On Wednesday, BlackRock chairman and CEO Larry Fink said, “It is my view that inflation is going to be more systematical. I believe it is a fundamental, foundational change in how we navigate economic policy…now we are saying jobs are more important than consumerism…. That is going to probably lead to systematically more inflation.” Source: CNBC via Twitter
In microeconomics, when debt is already at extreme levels, a further increase in debt leads to an increase in the risk premium on which a borrower will default, suggesting that the bank or other lender will not be repaid. As the risk premium rises, banks are often unable to price this additional cost through to their private sector borrowers, thus the loan to deposit ratio of the banks falls.
Economic jargon gets a little confusing for most of us, so I’ll try to distill it into something a little easier to understand. Think of the velocity of money as the movement of money in a system. Banks are important because they can leverage up their balance sheets and get money into the system via lending.
Hire workers with debt and you gain in productivity (more earnings hopefully), and your workers use that money for their needs. The people that earn money on the things your workers buy benefit, and the employees of those people benefit, and so on.
The more debt a business or individual has, the more risk there is that they can’t pay back that debt. If they can’t, the lender loses money. Banks start lending less, and since less money is going into the system, there’s a reduction in the velocity of money.
Lacy is saying that right now,
… there is too much debt. In terms of the impact on monetary activities, a drop in the LD (loan demand) ratio means that more of bank deposits are being directed to the purchase of Federal, Agency, and state and local securities in lieu of private sector loans.
The macroeconomic result is that funds are shifted to sectors that are the least productive engines of economic growth and away from the high multiplier ones.
This is an important insight since Aggregate Demand (AD), i.e., nominal GDP, by algebraic substitution, equals money times velocity. As velocity falls, then the AD curve simultaneously begins to retreat back to, or below, where it stood prior to an exogenous monetary or fiscal stimulus.
In plain English, adding more debt is not a benefit. From Lacy, “At the end of the day, each dollar of additional new government financed debt will reduce GDP by more than a dollar, therefore, the economy is worse off.”
Note the decline in velocity over the last 20 years:
Here’s a look at money velocity and the commercial bank loan/deposit ratio (1952–2020). Note the high correlation between the decline in loans vs. deposits and the decline in M2 velocity (chart from Hoisington’s quarterly letter):
Bottom line: From Lacy, “The weakness in the LD (loan/deposit) ratio, as well as the money multiplier, confirm that the banking system is not in a position to assist the Fed in achieving their goals for economic activity and inflation. The obstacle for both variables to function normally is the massive debt overhang.”
“Lower for longer,” Lacy concludes:
- The current economic growth and inflation rates of 2021 will be the highest for a very long time to come.
- The main obstacle to a return to sustained growth in the standard of living, extreme over-indebtedness, was dramatically worsened by the multiple rounds of fiscal stimulus, which has caused the temporary improvement in economic growth and inflation in the second quarter.
- No pathway out of this trap exists as long as the overreliance on debt remains the only tool of monetary and fiscal policy.
- The situation is no different in Japan and Europe. Thus, while long Treasury yields can increase over the short run, the fundamentals are too weak for yields to stay elevated.
- More debt does not cure a subpar economy mired in a debt trap.
- Given the above, our view is that the trend in long-term Treasury yields remains downward.
You can find the Hoisington Investment Management Q2 Quarterly Review and Outlook here.
It is hard to fight a true giant, and Lacy is a giant. Lower for longer is likely, and that seems to be the message from my favorite bond market indicators (see the link in the Trade Signals section below). My two cents is that, given how low interest rates are, and thus the large percentage swings in bond prices, make sure to marry the technical with the fundamentals. Trade bonds or have the stomach of a giant to buy-and-hold. In my view, market technicals should match the fundamental view. If not, protect your backside.
The balance of this week’s post is short. You’ll find a more detailed review of an equity market chart I shared with you last week, the latest Trade Signals commentary, and a short personal note. Thank you for reading!
- Important Sell Signal
- Trade Signals – High Yield Junk Bonds
- Personal Section – Fanness
Important Sell Signal
An 86% win rate is not 100%, but it is worth our attention. Last week, I shared the following chart with you. A member of CMG Team Mauldin mentioned to me that I didn’t quite stick the landing with my explanation of the chart. I’ll try to do that here.
I see many indicators out there and none of them are prefect. It’s easy to see that the market is overvalued, overleveraged, and euphoric. Yet, while risk is highest in such states, that doesn’t mean markets can’t go higher.
I have a fundamental view that we sit at the end of a long-term debt supercycle and find it hard to disagree with the views of Stan Druckenmiller, Felix Zulauf, Ray Dalio, Bill White, and my partner John Mauldin, to name a few I respect most (all of whom say in the end there will be inflation). And it’s hard to argue with Lacy!
Mauldin believes we are headed for “The Great Reset.” Think of it is the restructuring of the debt (MMT and defaults are probable) and a restructuring of the shamefully underfunded pension system. We owe too much, we’ve promised to pay more than we’ve got, and aging demographics won’t allow us to kick the can down the road much farther. Mauldin’s best guess is this reset plays out over the coming five years or so, but definitely this decade. Zulauf says you are going to need to be a trader to survive. I think he is right.
This next technical indicator has me on high alert. Here’s how to read the chart:
- The analysis looks at the number of new stock offerings and plots the data all the way back to 1969.
- There are two categories: too much supply (many offerings), and relatively few new stock offerings.
- The indicator looks for a change in the trend in new offerings. Signals, as you can see, are infrequent. A “sell” signal was just triggered on June 18.
Keep this in the back of your mind as you read the chart: When there are few initial public offerings (IPOs), it indicates that investors are cautious and that, generally speaking, smart-money insiders are bullish. These are good starting conditions.
When there is too much supply—many IPOs—it indicates that speculation is pervasive. During such times, insiders are generally bearish (as is the case today with record insider selling). These are bad starting conditions.
What we are looking for is a reversal in trend from either extreme––and that’s what just fired the first sell signal since early 2008.
- When the deviation from trend rises above and then falls below the upper green dotted line (bottom section), it’s a “sell” signal.
- When the deviation from trend falls below and then rises above the lower green dotted line (bottom section), it’s a “buy” signal.
- A few of the last “sell” signals are circled in red.
- Not perfect but worth noting. Lights on!
By the way, there are many ways to navigate the period ahead. There are several ETFs that give you broad-based equity market exposure and have risk management processes built into the ETF. Meaning, the advisor to the ETF can buy put options to hedge against major downside risk or use risk-on, risk-off signals. Others use simple moving averages. I have a few favorites, and we also like combining trading strategies to better diversify risk management. One could also look at the above chart, call his or her broker, and write some covered calls and buy put options to hedge. I don’t see the signal as bad news.
Trade Signals – High Yield Junk Bonds
July 14, 2021
Posted each Wednesday, Trade Signals looks at several of my favorite equity market, investor sentiment, fixed income, economic, recession, and gold market indicators.
For new readers – Trade Signals is organized into three sections:
- Market Commentary
- Trade Signals — Dashboard of Indicators
- Charts with Explanations
Notable this week:
Similar to the equity markets, the high yield junk bond market has remained robust. The trend in price is currently bullish. What I’m watching for is a change in trend. Why? The HY market has historically been an excellent early warning signal for recessions, default cycles and bear markets.
The following chart plots the price (red line) of the PIMCO High Yield Bond Fund. This mutual fund is large and broadly diversified fund that serves as a good proxy for the entire junk bond market. The green line is the 50-day moving average price line. Think of it as the trend in price over the last 50 days. A drop below the trend line will serve as an early alert warning.
There have been four major declines in the high yield bond market over the last several decades. Not shown is 1991 when Michael Milken got in trouble and Drexel Burnham went out of business. What all of the declines have in common is they occurred during recession. The change in trend in HY bond prices has served as an early warning in each of the recessions. Each signal served as an early warning for the equity markets as well.
Prior to March 2020 (COVID-19 recession), I often wrote that there were three major opportunities in the HY market and the fourth would be the best opportunity since I began trading HY in 1990. I was wrong. All of the money created by the Fed and its signaling it would be buying HY ETFs (they did buy but did not buy very much… the signaling did the trick) prevented opportunity number four from being the “epic” opportunity I expected.
From a credit quality standpoint, there remain many zombie companies living on nothing but debt with covenant protection the worst in history, I still expect the next default cycle (that’s when liquidity dries up) to be bigger than 1991, 2000, 2008, and 2020. So risk manage your HY bond exposure and I’ll bump my call to say that opportunity number five will be epic.
New signals this week: For short-term traders, notable this week is the sell signal in the S&P 500 Index Daily MACD Indicator. The intermediate-term signals remain bullish. All of the recession watch charts are updated… no sign of recession. In addition to the HY signal, the other bond market signals remain bullish. While still struggling performance wise in 2021, Gold remains in a bullish buy signal.
Click HERE to go to the balance of Wednesday’s Trade Signals post.
Not a recommendation for you to buy or sell any security. For information purposes only. Please talk with your advisor about needs, goals, time horizon and risk tolerances.
Personal Note – Fanness
Michael Jordan won five NBA championships while playing for the Chicago Bulls in the 1990s. Air Jordan, as he is nicknamed, was a ruthless competitor and perhaps the most skilled basketball player of all time.
During his reign, he played for coach Phil Jackson, a former player himself with a special gift for motivating his players, even Michael Jordan. He showed his players, each and every one of them, that he cared about them––and that’s what made him great.
Jackson would do some fun and quirky things. For example, to make sure a player knew he was thinking about him, Jackson would leave an inspirational note taped in his locker before game time.
After Jordan’s playing days were over, he reflected on the notes and quotes he had found in his locker over the years and told an audience that sometimes the messages were corny, sometimes they were interesting, and sometimes they were inspirational––but whenever he opened his locker and found a note from Jackson, it always made him feel special.
Even Michael Jordan, while winning NBA Championships, wanted to know Phil Jackson cared. No one is immune from needing encouragement and support.
A good friend of mine works for a firm called Admired Leadership. The firm, led by Randall Stutman, has studied top leaders and consults with Fortune 500 CEOs. Randall’s a humble guy with a passion to share what he has learned. If I could sum it all up, being someone’s fan, and letting them know it from time to time, is at the top of the list of leadership traits.
Much of what I wrote above is from a piece they have written called Fanness, which captures their approach to motivating and inspiring others. They share free insights in an email newsletter called “Admired Leadership Field Notes,” which you can sign up for. Periodically, I receive an email with some advice on leadership. They’re short and enjoyable.
My tip of the day: Hide a note in a place where someone you admire will find it. It will lift both of you and add a little more goodness to the world. Frankly, I need to do this a lot more…
Some more travel is in my near future. I’ll be in Boston at the end of the month and then on to Maine August 7–12. David Kotok’s annual Camp Kotok fishing get-together is August 12–15. Hope you have some fun plans in your immediate future.
Wishing you a wonderful week,
Stephen B. Blumenthal
Executive Chairman & CIO
CMG Capital Management Group, Inc.
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Stephen Blumenthal founded CMG Capital Management Group in 1992 and serves today as its Executive Chairman and CIO. Steve authors a free weekly e-letter entitled, “On My Radar.” Steve shares his views on macroeconomic research, valuations, portfolio construction, asset allocation and risk management.
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