Financial Repression Will Liberate Some Assets

Points of Return

Gold Fillings for the Fangs

Maybe it hasn't been such a bad year after all. Following promising news on Oxford University's search for a Covid-19 vaccine (and even though the news wasn't totally positive), the S&P 500 rose Monday, and at last closed in positive territory for the year. This was the first time this had happened since the spread of the coronavirus became apparent in February. Meanwhile, the dominant internet groups in the NYSE Fang+ index reversed recent declines to hit a new all-time high:

As has been said many times, it seems extraordinary for the world's largest stock market to be showing a profit for a year in which so many bad things have happened, and remain unresolved. More specifically, this latest bout of strength has been fueled by a return to an alarming narrowness, which has seen the biggest "mega-caps" rise while small companies languish, and value stocks look ever cheaper compared to growth companies. It had appeared as though the rally was broadening, as we would expect if an economic recovery were taking shape. Not anymore:

To rehearse another point made many times, the stock market as a whole is doing so well because the world is awash with liquidity. With rates virtually zero and central banks ready to buy, debt issuance in developed markets during the second quarter was at previously undreamed-of record levels, as shown by a new report from the Institute of International Finance.

This isn't just an American phenomenon. As the IIF shows, there was a sharp rise in all forms of debt, measured as a share of GDP, across the world in the first quarter. China took the lead, despite the apparently more conservative approach of the People's Bank of China. Such increases haven't been costless. Globally, the face value of corporate defaults in the second quarter was the highest on record (although as a proportion of all bond issues it remained slightly below the worst default rate from the Great Recession). So the rise in indebtedness has plainly been accompanied by rising risk. Corporate dividend yields may indeed be more generous than the yields on government bonds these days — but there is a still a risk that companies won't be able to pay those dividends (or even repay the principal on debt):

Overall, and most sobering, the IIF's count shows debt hit an all-time high by the end of the first quarter, before the splurge of corporate issuance and government spending to cushion the impact of the pandemic. This is true globally, whether debt is counted in dollar terms, or as a percentage of GDP:

What relevance does this have for stocks? The low rates on debt are a (valid) argument for paying more for equities, all else equal. But the amounts being issued imply that supply of bonds could soon swamp demand and push up yields. At least unless central banks intervene. In another landmark Monday, real 10-year yields dropped to a fresh low for this cycle. They are now lower than at any time since December 2012. The way real yields reached this place is interesting. Extending a market trend that has persisted since March, the 10-year yield on conventional bonds remains almost ironing-board flat at a little over 0.6%. The fall in real yields is driven entirely by rising inflation expectations, as shown by the rate needed for fixed and inflation-adjusted bonds to break even:

This looks like "financial repression." Yields will be held steady, and we will have no choice but to lend to the government at ever worse real rates. Stocks might offer some kind of a haven from such repression, but perhaps the most obvious shelter is gold — which has also, entirely uncoincidentally, hit its highest in almost a decade. Gold's chief problem as an asset is that it pays no yield. It therefore becomes far more attractive when the real yield on alternative investments becomes negative — and as this chart, with an inverted gold price, shows, lower real yields lead inexorably to higher gold prices:

There are other ways to show that gold should benefit from the current extraordinary monetary conditions. In this chart from CrossBorder Capital Ltd., the gold price's deviation from its trend is plotted against the combined liquidity of the U.S. and China. Over the last 20 years there has been a clear relationship. 

If the Fed and other central banks are determined to stick with financial repression, and this great piece by Bloomberg Opinion colleague Tim Duy suggests that they are, then real yields should fall further, liquidity should continue to bubble, and gold should continue to be a good bet. How much further could this go? 

CrossBorder Capital does some calculations comparing total U.S. debt with the gold price, going back a century. The average total value of debt outstanding in gold terms turns out to be about 30 billion ounces. 

To get back to that level from where we are now would require an increase in the gold price of about 40%. More debt would mean a higher gold price. 

The stock rally at present still doesn't show great confidence in an economic recovery, but the bond market does suggest high confidence in financial repression for a long time into the future. To benefit from that repression, it might be worth taking on some gold. After all, the Fangs may yet need some fillings.


Word-Crunching Corona

Which companies were best prepared for remote operations when Covid-19 hit? This knowledge would have been valuable indeed at the time, and could still be useful. And to find out, the quants at MSCI Inc., the indexing group, show in new research that it was necessary to crunch words rather than numbers.

Their idea, using machine learning, is to look for words most associated with being able to operate remotely. Here is the word cloud they developed:

Next, they scraped through companies' 10-K statements using a series of different techniques to see how often the words recurred. One was a simple word count directly from the 10-Ks. A follow-up was a semantic search, which identified the companies' core services and products, and then looked at how many times the keywords appeared in their documentation. Finally, and most esoterically, they searched for "concept exposure," which involves looking for concepts with which a company is most often associated, and then finding out how many of the keywords are related to these. 

The result was the following. Over the year to date, all the portfolios built using the exercise did significantly better than the MSCI USA index. A simple word count did best of the three methods, although MSCI's index of the top remote-operating companies that used all three measures was better still.

Not surprisingly, it turns out that the companies identified this way tended to be in line with the investment factors that have performed best over the last year, such as growth and momentum, and not to show much in the way of value. Whether they realized that these companies were well suited to working remotely or not, markets did pick up the notion that they were doing well:

The greatest problem with this survey, I fear, is revealed by the sectoral breakdown, which shows that technology companies dominated. This might be because they are naturally full of people who are au fait with working remotely. But it is also quite possible that such companies will need to use words like "website," "digital" and "technologies" much more often than other companies. The real prize would be a sector-neutral list of the more traditional companies that are particularly well-equipped to deal with a pandemic. This chart shows the extent to which technology companies are overweighted:

None of this should take away, however, from the fact that this exercise was based on evidence available before the coronavirus struck. Few of us were able to sit down and think calmly through all the possibilities and implications during those hectic weeks in February and March. But if we had, and we had set our machine learning tools to go looking for companies that might do well when working remotely, we could have beaten the market handily. It is certainly worthwhile for the quants to carry on with this work. 


European Summit Update

The summit of European heads of state in Brussels, which is trying to thrash out a jointly funded "recovery fund" to aid countries worst hit by Covid-19, was originally scheduled as a two-day meeting to end Saturday. At the time of writing (early Tuesday morning in Brussels), it is into its fifth day, and there is still no agreement. The key points appear to be:

  • There will be a deal: some kind of recovery fund is going to happen
  • It is nothing like as ambitious as France, Germany, the European Commission and the main likely recipients had hoped
  • The "Frugal 4" (the Netherlands, Austria, Denmark and Sweden) have ensured a much greater weight toward loans, rather than grants
  • The Frugal 4 have also won a lot of rebates for themselves, along with a lot of abuse and possibly lasting grievance
  • The "Illiberal 2" (Hungary and Poland) have avoided any conditions relating to the "rule of law," or in other words their backsliding from democracy

The lasting impressions will be that anyone can hold up the EU, that the commission can be blackmailed, and that the EU is powerless to stop the descent into authoritarianism that is under way in Hungary and could easily spread. As far as the future of the European project is concerned, the first point is just about enough to avoid being outweighed by all the others. This is a step toward fiscal coherence. If the European project is to survive at all (and there are plenty who think that it shouldn't) it must become more fiscally coherent. So that is good. 

Markets certainly seemed to enjoy the impasse. The spread of Italian over German bond yields tightened and the euro strengthened against the dollar, in both cases to levels not seen since before the Covid-19 outbreak reached Europe:

The actual terms matter greatly. But at this point, rather than hang around to see a final communique, I am inclined to point you to this excellent production of Samuel Beckett's Waiting for Godot. As to who will arrive first out of Godot or a common European fiscal policy, it's anyone's guess. 


Survival Tips

As some people find Waiting for Godot and Amadeus a tad heavy, I will recommend a cartoon to view on YouTube. The only catch is that it's about the Spanish flu of 1918. As strongly recommended by my son Jamie, and watched by me, Extra History — The 1918 Flu Pandemic is as good a history of the greatest pandemic of modern times as I have seen. As it was made well before the advent of Covid-19, it's also prescient.  The rest of the Extra History franchise is well worth exploring too. Enjoy.

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