On My Radar: In 2017…Watch Europe, Watch China and Watch Japan; “Stay Wary, Alert and Very, VeryLearn more about this firm
“Stay wary, alert and very, very nimble.”
– Art Cashin
Managing Director, UBS Financial Services
I read Art’s letter almost every day and, boy, do I enjoy his wit, his compassion and his brains. In the spirit of Christmas, his post this morning was fun.
‘Tis three days before Christmas
and at each brokerage house
The only thing stirring
was the click of a mouse
Down on the Exchange
the tape inches along
Brokers bargained and traded
as they hummed an old song
The Fed turned data dependent
or so they would claim
Yet they hiked in December
though the data looked tame
He touched on the Cubs, the Broncos and LeBron… my favorite part was:
Don’t let this year’s problems
impede Christmas Cheer
Resolve to be happy
throughout the New Year
And resist ye Grinch feelings
let joy never stop
Put the bad at the bottom
keep the good on the top
So count up your blessings
along with your worth
You’re still living here
in the best place on earth
And think ye of wonders
that light children’s eyes
And hope Santa will bring you
that Christmas surprise
With joy on our minds and hope in our hearts, let us step forward and not let the bond market tear us apart. Sorry about that… Art’s jingle is in my head.
I’m on record saying the low in bonds is IN. I continue to believe we are entering a phase of rising interest rates. In such environments, bonds perform poorly. It’s starting to get dicey globally and the evidence is showing up in the bond market. Let’s see what is going on that may or may not be fully “on your radar.” This from Wolf Richter, founder of Wolf Street:
“All kinds of things are now happening in the world of bonds that haven’t happened before. For example, authorities in China today halted trading for the first time ever in futures contracts of government bonds, after prices had swooned, with the 10-year yield hitting 3.4%. Trading didn’t resume until after the People’s Bank of China injected $22 billion into the short-term money market.
What does this turmoil have to do with US Treasurys? China has been dumping them to stave off problems in its own house….”
The move won’t be straight up though it has felt that way over the last few months. If you are long government bonds (including longer-dated municipals), my two cents is to use rallies (declines in interest rates) to shorten your maturity exposures.
The biggest bubble of all bubbles sits in the government bond market. Particularly in the developed world… here, there and everywhere. Governments’ choices? Inflate the problem away, raise taxes, and sell assets or default. Or all of the above. Right now it is inflate and seek growth. Currency gamesmanship or more pointedly “currency wars” steps into the fray. The imbalances are great.
I believe we will see a sovereign debt default first in Europe. The EU is improperly bolted together and protectionism is on the rise. Brexit is a sign. The U.S. election is a sign. The Italian Referendum is a sign. And we are seeing serious problems with government debt emerge outside of the U.S.
The European Central Bank now owns 15% of Germany’s national debt. Much of it at negative yields. The ECB remains on its bond buying spree though they are running out of positive yielding bonds to buy.
Further, the ECB is buying up the troubled debt from the books of the troubled banks and there appears to be a long way to go. Troubled isn’t just the higher risk junk bond corporate bets, trouble are the sovereign government bonds from Greece, Italy, Portugal and Spain. I can’t help but think we will one day look back and reflect on just how surreal, crazy, insane this period turned out to be.
Here in the U.S. the Fed now owns $2.4 trillion of the roughly $20 trillion in U.S. government debt. In Japan, retirees are no longer buying Japanese government bonds. When Abe came to power, the private sector held 177% of the debt-to-GDP. They now own approximately 75%. The citizens are selling. The BoJ steps in — print and buy… the Bank of Japan owns more of the debt than the private sector. Print and buy… the Japanese Central Bank owned 60% of the nation’s ETFs as of June 2016.
See Bloomberg’s The Bank of Japan’s Unstoppable Rise to Shareholder No. 1
In 2016, Japan joined Europe in the great experiment of modern monetary policy: negative interest rates to spur inflation. Will it work? In the short term, yes; in the long term, I don’t think so.
That’s the bet you and I are faced with. With rates still near 5,000-year lows, the risk reward makes zero sense to me. We are dependent on central bankers. I’m nervous.
OK… as depressing as that sounds, it need not be. There is an upside and it is this: I believe we are heading towards an investment opportunity of a lifetime. To get there, play more defense than offense. Look at valuation levels, look at the age of the bull market move. Have a plan in place to risk protect what you’ve got. I favor trend following and for now the equity market trend remains bullish.
Participate and protect and keep the great Sir John Templeton in the back of your mind. The single best advice I ever received was in 1985. Mr. Templeton told me (and of course many others many times since) that the secret to his success was he was able to: “[b]uy when everyone else was selling and sell when everyone else was buying.”
Watch out for over confidence, don’t follow the masses. This is a game of opposites. Don’t fall into the buy-and-hold forever trap. Most can’t do it. Put stop-losses in place. Use the 200-day moving average rule to stop-loss protect your equity exposure and/or buy 15% out-of-the money put options to hedge your exposure.
Further, watch what is going on in Europe. Watch China, watch Japan. Debt is the global issue. All are trying to grow out of the mess. Odds are rough. The U.S. is by no means healthy from a debt-to-GDP perspective, but we look to be the cleanest shirt in the laundry pile.
When confidence in governments is lost, the money will run to where it is treated best. That is likely to be U.S. stocks. A melt up in prices and valuations? Maybe. I hope so but I’m going to make sure I am risk minded along the way.
Heat up that coffee and find your favorite chair. I’ve included a Pension Fund Red Ink chart for you this week so you can see just how underfunded your particular state is (most recent available data). Also, keep what is happening in the U.S. Treasury bond market front of mind. You’ll find a great article (charts) to that end below.
Most importantly, celebrate your family, hug your kids and take an extra second to send some love to the world. Please know how grateful I am that you take time to read my commentary each week.
Merry Christmas and Happy Holidays to you and those you love most! I’m going to take the week off next week and recharge for the New Year. There will be no On My Radar next Friday.
Included in this week’s On My Radar:
- Pension Fund Red Ink – Check Out Your State (Chart)
- Foreigners are Dumping Treasury Bonds at Record Rate
- The Year in Review
- Trade Signals – Strong Dollar, Weak Gold, Equity Trend Up, Bond Trend Down, Sentiment Remains Far Too Optimistic
Pension Fund Red Ink
Last week I shared with you that the California Public Employees Retirement System, better known as CalPERS, stated that a 7.5% annual return is no longer realistic. To which I added, finally, amen, right on. The new actuarial target is 7%. That still seems high to me.
Forward 10-year probable returns for equities are in the 3% to 4% range. Hussman is projecting negative 12-year coming returns. Jeremy Grantham and his team at GMO sees seven-year coming returns even lower. Note the -3% real returns for large cap stocks and -2.3% for small cap stocks (real means returns after inflation).
And with bonds yielding 2.5%? Bonds will get us 2.5% over the coming 10 years. Timber and Emerging Markets at 4.4%.
The headwind to that now 7% actuarial return target? High valuations and low yields. Unless the pension funds are the world’s greatest market timers, which they are not, 7% is not going to happen.
I believe 5% to 6% is doable. Smart beta and other factor-based ETFs. But hedge your equity exposure as a lot of the ammo in the central bank arsenal has been spent. The next recession, and it’s coming, will be more challenging that most. Too, the largest recession driven corrections occur when your starting point is one of excessively high valuations.
With valuations at the second highest in history, it is wise to play defense now and get more aggressive later. In the meantime… patience.
As I reread last week’s piece, I found myself upset with myself for not sharing this next chart.
To that end, I was curious about my state and you may be curious about yours. I’ll be talking to Susan about moving to Florida before Pennsylvania hikes the tax rate…
Here’s a look:
After years of not setting aside enough money, state pension funds are looking at a $1 trillion shortfall in what they owe workers in benefits, according to a new analysis from The Pew Charitable Trusts.
Pennsylvania is sitting at approximately 68% funded. The sixth worst state in the Union. Illinois and Kentucky are near 45% funded.
This is a mess, my friend. And it is worse than the above chart reflects. Recall from last week’s piece that CalPERS lowered their return assumptions from 7.5% to 7%. The underfunded numbers above are using 2014 return assumptions. Lower the return assumptions and the underfunded problem grows worse.
Note in the next chart that at the end of 2014, 54.9% in the fixed income and cash allocation bucket has not done so well YTD.
Widening gap: The data in the next chart is through fiscal year 2014. The funding gap is expected to top $1 trillion in fiscal 2015 (we’ll get that number soon). Further, with an estimated 55% in bonds, 30% in stocks and 15% in alts, my back of the napkin math looks like a 5% 2016 return year for pensions.
That bond portion of pension portfolios has been hit hard while the stock portion has gained approximately 10%. So take 55% of the 2.19% YTD return for “BND” (Vanguard Total Bond Market ETF), 30% of 9.77% for “SPY” (SPDR S&P 500 ETF) and 15% of 7% (a rough estimate for alternative investments) and you get roughly 5%.
All in, it’s a pretty safe guess that the funding shortfall is higher today than it was in 2014. The aging population and returns under the 7.5% actuarial targets are the culprits. Expect higher taxes in the more troubled states.
One last chart on the subject:
A ranking of the 50 states and Puerto Rico based on their fiscal solvency in five separate categories:
- Cash solvency. Does a state have enough cash on hand to cover its short-term bills?
- Budget solvency. Can a state cover its fiscal year spending with current revenues, or does it have a budget shortfall?
- Long-run solvency. Can a state meet its long-term spending commitments? Will there be enough money to cushion it from economic shocks or other long-term fiscal risks?
- Service-level solvency. How much “fiscal slack” does a state have to increase spending if citizens demand more services?
- Trust fund solvency. How much debt does a state have? How large are its unfunded pen-sion and healthcare liabilities?
Everyone is Dumping Treasurys
All kinds of things are now happening in the world of bonds that haven’t happened before. For example, authorities in China today halted trading for the first time ever in futures contracts of government bonds, after prices had swooned, with the 10-year yield hitting 3.4%. Trading didn’t resume until after the People’s Bank of China injected $22 billion into the short-term money market.
What does this turmoil have to do with US Treasurys? China has been dumping them to stave off problems in its own house….
The US Treasury Department released its Treasury International Capital data for October, and what it said about the dynamics of Treasury securities is a doozy of historic proportions.
Net “acquisitions” of Treasury bonds and notes by “private” investors amounted to a negative $18.3 billion in October, according to the TIC data. In other words, “private” foreign investors sold $18.3 billion more than they bought. And “official” foreign investors, which include central banks, dumped a net $45.3 billion in Treasury bonds and notes. Combined, they unloaded $63.5 billion in October.
In September, these foreign entities had already dumped a record $76.6 billion. They have now dumped Treasury paper for seven months in a row. Over the past 12 months through October, they unloaded $318.2 billion:
A 12-month selling spree of this magnitude has never occurred before. There have been a few months of timid net selling in 2012, and some in 2013, and a few in 2014, but no big deal because the Fed was buying under its QE programs. But then, with QE tapered out of the way, the selling picked up in 2015, and has sharply accelerated in 2016.
This chart (via Trading Economics), going back to the early 1980s, shows just how historic this wholesale dumping (circled in red) of US Treasury bonds and notes by foreign entities has been:
The chart is particularly telling: It shows in brutal clarity that foreign buyers funded the $1 trillion-and-over annual deficits during and after the Financial Crisis, with net purchases in several months exceeding $100 billion. The other big buyer was the Fed.
But since last year, the world has changed. China, once the largest holder of US Treasurys, has been busy trying to keep a lid on its own financial problems that are threatening to boil over. It’s trying to prop up the yuan. It’s trying furiously to stem rampant capital flight. It’s trying to keep its asset bubbles, particularly in the property sector, from getting bigger and from imploding – all at the same time. And in doing so, it has been selling foreign exchange reserves hand over fist.
According to the TIC data (market price adjusted), China was the largest seller in October, unloading $41 billion. Over the last six months, it unloaded $128 billion. This slashed its holdings of Treasury securities to $1.116 trillion, below the holdings of Japan. Japan, now the largest holder of Treasury securities, reduced its holdings by $4.5 billion in October to $1.132 trillion.
Japan and China are by far the largest two creditors of the US – the US still owes them $2.25 trillion – and they’re cutting back their lending.
But who’s buying this paper? For every seller, there must be a buyer. But when demand sags, sellers have to offer a better deal. So they have to cut the price – for buyers, it means that the yield rises and becomes more attractive. The yield of the 10-year Treasury has nearly doubled since July this year, settling today at 2.60%:
At this yield, Treasurys found buyers today. But the remaining buyers – now that the biggest holders have turned into sellers – may demand even higher yields in the future. This comes on top of a lot of new supply: Over the last 24 months, the US gross national debt has ballooned by $1.85 trillion, or by about $925 billion per 12-month period (using the two-year average eliminates the distortions of the debt ceiling fight). Soon, the US gross national debt will hit $20 trillion.
And given President-Elect Trump’s ambitious deficit-spending and tax-cut programs, a lot more debt may soon wash over the market. But this time, neither China nor Japan, nor the other major foreign entities may be willing and able to bail out the US, as they’ve done during and after the Financial Crisis. The bond market sees this too. Hence, the bloodletting in Treasurys, considered among the most conservative investments in the world.
The Year in Review — Choppy
In early November, the two-year return on the S&P 500 Index stood at just 3%. Then the election and the post Trump rally.
- Stocks gyrated much the year after selling off hard December 2015 through February 2016 before climbing to record highs this month, the dollar soared and bond prices fell.
- Recall the December 2015 Fed rate increase? That December 2015 Federal Reserve rate increase along with expected further hikes set fear in place that the U.S. would be headed into recession.
- January began with a panic. By February 11, the Dow Jones Industrials was down more than 10%, and New York oil futures fell to $26.21 a barrel.
- China was next to step center stage. Investors feared China faced a “hard landing” after years of rapid growth. China adjusted their currency and the market took note.
The fear receded by March after the ECB, Bank of Japan, China and the Fed met in Shanghai and arrived at a temporary “currency truce” understanding.
- Central bank policy makers spoke up and market calm returned.
- Japan joined Europe in the great experiment of modern monetary policy: negative interest rates to spur inflation.
- The Bank of Japan’s embrace of negative interest rates also signaled bad news for the global economy. Negative rates would later spread to much of Europe.
- Call it Keynesian craziness.
- The Brexit surprise followed on June 23.
- S. bond yields made what may be a 35-year low in early July. The 10-year hit 1.36% and sits at over 2.55% today. It is not your father’s bond market.
- Trump surprised in November. The people feel underserved and frankly fed up with government.
- The year closed with a party, as Wall Street bet a Donald Trump administration would end the era of ultralow interest rates and spark higher U.S. growth and inflation.
- Through the November election, it was a choppy, trendless and overall challenging for momentum-based trading. Post-election, a better trend environment appears to have returned.
As we move into 2017, keep Paul Tudor Jones’ sage advice in the back of your head, “The whole trick in investing is: “How do I keep from losing everything?”
Trade Signals – Strong Dollar, Weak Gold, Equity Trend Up, Bond Trend Down, Sentiment Remains Far Too Optimistic (posted 12-21-2016)
S&P 500 Index — 2,267 (12-21-16)
Posted each Wednesday, Trade Signals looks at several of my favorite stock, investor sentiment and bond market indicators. It is my weekly risk management dashboard, designed to keep me better in sync with the major technical trends. I hope you find the information helpful in your work.
Bullish investor sentiment for stocks recently peaked at 83%. That is a high reading and signals caution for stock investors. It was at 14% bullish on November 3, 2016. Readings below 41.5% indicate a high level of investor pessimism. Readings above 62.5% indicate a high level of investor optimism.
It looks something like this:
- Extreme Pessimism is short-term bullish for equities
- Extreme Optimism is short-term bearish for equities
(See the Investor Sentiment charts below)
Sentiment can help with timing your buying decisions. Overall trend based evidence can help you identify bull and bear market cycles. The trend for equities remains bullish. The trend for bonds bearish and the trend for gold remains bearish.
Today’s bullish sentiment suggests caution. I find myself in the “buy the Trump dip” mindset and advise to use the 200-day moving average line on equity positions to set stops losses. And/or diversify to a handful of go anywhere ETF trading strategies.
Valuations are high, yields are low. Risk remains high.