Yields on 10-year U.S. Treasuries (UST) spiked 0.5 percentage points over a seven-week period ending February 21st to a recent high of 2.94%. While yields backed-down to 2.74% at March-end, the upward pace still warrants discussion. After all, rising bond yields are widely-considered to be the catalyst for the 10% sell-off in U.S. equities – one of the swiftest in history with the S&P 500 Index falling 11.8% in 10 trading days – that remain well-below the highs reached on January 26th.
What’s more, we believe the bond market has passed an inflection point and expect yields on 10-year UST to test and surpass their February high-point, as rates march upwards in the days and months ahead, causing future equity sell-offs that, in turn, will mute overall gains for 2018. Our forward view on yields parallels recent revisions from Wall Street research analysts, including Goldman Sachs that lifted expectations for 10-year UST yields to 3.25% in 2018 and 3.6% in 2019, which are well above futures forecasts that imply the 3% threshold will not be passed until 2019. To give some idea for the possible downside, were yields on 10-year UST to reach 4.5% in 2018, equity prices could fall by 20-25%, according to Goldman Sachs.[1] Those figures are within medium-term range, when compared to the average rate in 2007 of 4.63%.
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Why the sudden increase in yields? Firstly, the upward shift in yields is not a total shock because U.S. tax reform and budget legislation led the Federal Reserve Open Markets Committee (FOMC) to reaffirm its commitment to lifting the federal funds rate three times in 2018 – one increase took place last month – and, typically, government debt trades in-line with where investors expect central banks to set future rates. But, changes in investor expectations explain only 1/3 of the movement in yields, according to Federal Reserve data. Instead, the bulk is attributable to an increase in ‘term premium’ or the extra compensation required by investors to hold longer-term debt, a function of supply/demand. That means 2/3 of the recent rise in yields is related to excess supply over demand, which implies investors are selling.
Normally, a FOMC pledge to raise interest rates would lure global investors to the U.S. dollar (USD), causing it to strengthen against foreign currencies, but the opposite has played-out. In the first quarter (Q1) of 2018, the USD weakened by 3.6% against its 16 key trade partners, marking its fifth consecutive quarterly decline and a 12-month loss of 7.3%. The most logical explanation for the conflicting data (of higher yields and a weak USD) is that foreign investors, who collectively hold $6.3 trillion or 41% of the $14.9 trillion UST market, are selling. That view is supported by the broad decline in foreign participation in U.S. debt auctions in the last three-years. Since 2015, foreigners have purchased $151 billion or 9% of the $1.59 trillion of debt issued by the U.S. Treasury, which compares with a 40-60% range after the 2008 recession. Last year, the same figure fell to 5%.
While it’s impossible to trace the exact source, data from the Ministry of Finance suggests the February UST sell-off originated in Japan, the second largest holder of UST with $1.1 trillion, where local investors sold a net ¥2.1 trillion ($19.6 billion) in foreign debt in the three-weeks ending February 17th. Those figures help explain the 6.1% rise in the Japanese yen vis-à-vis the USD in Q1 2018, and suggest an acceleration of the trend, rather than a change of course. For the first-time since 2013, Japanese investors turned net sellers of UST last year, with holdings falling by 3.83 trillion yen ($35 billion), according to the Bank of Japan, which has reduced its holdings by 12% or $141 billion since 2015. A similar pattern is observable in the European Union (EU), where investors became net sellers of UST in 2017, marking a stark reversal from the prior period, where ECB data shows EU investors representing +50% of foreign purchases of UST since 2015.
More recently, in January, well-before current tariff threats, senior government officials in Beijing recommended the People’s Bank of China (PBOC), the largest holder of UST with $1.2 trillion, slow or halt UST purchases.[2] Shortly thereafter, China’s most prominent rating agency, Dagong Global Credit Rating Co., cut the sovereign rating of U.S. Government debt from A- to BBB+ with a negative forward outlook, citing: “The increasing reliance on the debt-driven mode of economic development will continue to erode the solvency of the federal government.” The BBB+ rating notably puts the U.S. on par with Colombia and Peru and below Russia.
Why the foreign uproar? Based on the timing of events, what seems clear is the UST sell-off (that has lifted the term premium) is a signal that foreign investors are unhappy with recent U.S. legislation to (i) reduce taxes by $1.5 trillion in the next decade and (ii) increase the ceiling on discretionary spending during the next two-years. As a result, the Congressional Budget Office (CBO) has revised its 10-year forecasts to show the cumulative federal deficit increasing by $1.6 trillion to $11.7 trillion, which contradict claims from the Trump Administration that new revenue will offset higher deficits. There is also little precedent for such government stimulus when unemployment is low – it is unusual for the federal deficit to expand significantly outside of wars or recessions – so we are in unchartered economic territory. This point was highlighted in FOMC minutes last month, where participants: “Generally regarded the magnitude and timing of the economic effects of the fiscal policy changes as uncertain, partly because there have been few historical examples of expansionary fiscal policy being implemented when the economy was operating at a high level of resource utilization.”
For investors, the immediate problem is that deficits will be front-loaded, with CBO estimates showing the federal deficit reaching $804 billion this year, up $242 billion from prior June estimates, and $1 trillion in 2020, two years earlier than prior estimates. Analysts at Barclays now expect total net Treasury borrowing to rise from $550 billion in 2017 to $1 trillion in 2018. The $450 billion UST supply increase, the most since 2010, comes at a time, when there is already investor anxiety about FOMC plans to shed $2 trillion from its $4.5 trillion balance sheet in the next four-years, including reductions of $225 billion in 2018 and $351 billion in 2019. These are large numbers, when compared to the $248 billion of UST held by Switzerland. The FOMC initiated the unwinding process last October, with $12 billion of UST rolling-off per month today and gradual increases planned (up to a maximum of $30 billion) thru this October. As the FOMC slows the amount of maturing government debt it reinvests, the Treasury must fill-the-gap with outside investment, so the withdrawal of stimulus amounts to incremental UST supply, which suggests higher yields. Prices are always hurt, when the biggest buyer leaves the auction place, and the same should be expected here.
Net Supply Increase for U.S. Treasuries in 2018
To compound matters, U.S. tax reform has permanently changed the way companies will manage their overseas cash, curtailing future UST demand. Prior to recent reform, multinationals retained earnings (estimated at $2.2 trillion) in the form of short-term USD denominated assets to avoid adverse tax treatment. An FT Analysis of 30 US companies showed cash and marketable securities of $1.2 trillion, of which $369 billion was in U.S. government debt. Those figures contain $252 billion in “generally based” USD-denominated holdings of Apple Inc. that include $55 billion of UST, an amount that ranks it ahead of countries like Norway and behind the United Arab Emirates. But, new reform has diminished the incentive to keep cash abroad and provided a rationale for multinationals to reduce current holdings. After all, we can expect Apple, Inc. will fund its forthcoming $38 billion tax payment, by selling-down a corresponding amount of UST.
Here we find ‘the rub.’ To fund the deficit, the U.S. Treasury is planning (i) a $450 billion increase in supply, as (ii) the FOMC reduces its demand by $225 billion and (iii) U.S multinationals begin to exit the market, where a (minimum) net supply decline of $75 in 2018 should be expected. Who will absorb the $750 billion supply increase? That’s the question of the hour. While a great deal of attention is devoted to FOMC targets, what matters most is the price (or yield) required to attract new investors, a function of supply and demand. On March 6th, Robert Kaplan, president of the Dallas Federal Reserve, highlighted this point: “My concern would be part of the yield increase may be the prospect of greater U.S. [debt] supply that has to get sold in the years ahead. That would be a more ominous reason for the increase in yields.” FOMC Chairman, Jerome Powell, put it differently to Congress last month, saying: “If money goes to other safe have assets that makes higher rates here.”
With a 3% U.S. domestic savings rate, what seems clear is the Treasury will need to bridge-the-gap with capital from foreign investors, who will increasingly demand higher yields to compensate for added risk. That process is already in motion. In February, the Treasury issued a record amount of short-dated debt and foreign investors (as if by design) purchased their largest share of Treasuries at auction since 2016. Most of the new demand came from foreign central banks, who collectively held at March-end $3.1 trillion, a rise of 7% from last year that mirrors the weakening of the USD in the period. The Treasury will issue an additional $96 billion of two-, five-, and seven-year UST next week, the largest slate of fixed-income coupon sales since 2014, so rates will likely be on the rise.
Moving forward, we can confidently say that yields on short-term UST will continue to rise in lock-step with FOMC rate increases, so the front edge of the curve will remain under pressure. The Treasury has issued a record amount of short-term debt this year, causing yields on two-year UST to be pushed-up in relation to 10-year yields, such that their difference (or 2/10 curve) has compressed from 112bps last year to less than 46bps, the narrowest since 2007. That amounts to a flattening of the yield curve, a key barometer of economic health, where curves with positive slopes denote growth and flattening weakness. With the FOMC on course for two rate increases this year, we are faced with a situation where the difference in the 2/10 curve could erode completely, if long-term rates do not shift upwards. James Bullard, president of the St. Louis Federal Reserve, recently noted: “I’m getting concerned about the flattening yield curve. If the committee pushes ahead with the rate increases and longer rates don’t cooperate, we could have an inverted yield curve within six months.”
We are left with two possible extremes, in the next six-months. Either (1) long-term yields shift upwards in parallel with short-term rates or (2) the latter exceeds the former, leading to an inverted yield curve. Both scenarios will hurt equity prices. Short-term rates have exceeded longer-term rates, leading to an inverted curve, before each recession since at least 1975, so it is a “very clear symbol the economy’s about to go into a recession,” to quote John Williams, president of the Federal Reserve Bank of San Francisco, who told an audience this month that he expects long-term rates to rise, as the FOMC lifts rates and shrinks its balance sheet. We believe the answer lies in-the-middle, and suspect 10-year UST yields will reach (at least) 3.25% by year-end, while the probability of an inverted yield curve (or recession) next year is now as high as 1-in-2, in our minds.
We can also be certain the increase in short-term UST supply will ‘crowd-out’ or attract capital from other fixed income markets, including the $6.2 trillion U.S. corporate debt market that has grown 2.5x from December 2008 levels of $2.5 trillion. The impact of higher UST yields is further evident in the London interbank lending rate (LIBOR) that has climbed in the last three-months from 1.7% to 2.3%, the highest level since November 2008. LIBOR measures the cost for banks to lend to one another and is used to set interest rates on $350 trillion of financial contracts in derivatives and debt globally, so lending costs have already risen for many borrowers. S&P Global recently warned investors of risks in the corporate bond market, where leverage in the U.S. and Europe has reached a Net Debt/EBITDA ratio of 5.0x, which exceeds levels seen in the U.S. before the 2008 financial crisis.[3] “History shows us that the worst debt transactions are done at the best of times,” notes S&P analyst, Paul Draffin. ”Now is the perfect time to be cautious.” International Monetary Fund (IMF) analysts have painted a much harsher picture, with estimates showing between 20% to 22% of U.S. corporates facing default in the next recession.[4]
The most obvious victims will be distressed U.S. retailers that, by 2020, need to refinance $15 billion of debt, of which $6 billion is likely to result in defaults in the next 12-months, according to Fitch Ratings. Our biggest fear is that the recent Toys R’ Us bankruptcy – with 735 store closures in the U.S. and 31,000 layoffs – is a harbinger of what is to come in the retail sector that represented 10.7% of U.S. non-farm payrolls in February or 15.9 million jobs, a figure that is 11.2% higher than the cycle-low point set in December 2009. It is not hard for us to envision a scenario like 2008 and 2009, when retail employment fell by 5.0% and 2.7%, respectively. The problems are likely to persist too. For each 100bps increase in U.S. online penetration, now at 16% of total sales, an additional 9,000 stores will need to close to maintain the current sales per store level, according to UBS research, which equates the size of closures with seven Toys R’ Us chains. Meanwhile, higher yields will put downward pressure on the U.S. real estate market, where the effects of recent tax legislation have yet to be reflected in prices. New construction is further highly sensitive to rate changes, so a slow-down in new construction is likely (over time) to manifest itself in sector job losses, as workers walk-off finished sites into the unemployment line. The construction sector has traditionally been a key contributor to unemployment in recessions, with losses totaling 2.4 million or 24% of total between 2007 and 2010, and a similar scenario could materialize in the next 24-months. That’s our concern.
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How to respond? Like any patient that has just received bad news from the doctor, the first-order is recognize the illness exists. To quote Mark Twain, “Denial isn’t just a river in Egypt.” The message here is that forward yields suggest we are in the late-stage of economic expansion, so it’s time to reposition. Having held it near zero for seven-years, the FOMC has lifted the federal funds rate six times since the end of 2015 to the current range of 1.5%-1.75%, with two additional increases planned in 2018 and three in 2019. We are staring at the end of ‘easy money’ here, so liquidity is in decline, which means we should expect increased volatility, steeper sell-offs, and a higher probability of recession. After all, there have been 13 FOMC tightening cycles since 1950 and 10 (or 77%) have ended in recession, so the odds of the central bank engineering a ‘soft-landing’ are relatively low.
As with any early diagnosis, there is both ‘good’ and ‘bad’ news. The former is that there is no sign of an imminent recession this year, so the upward trend in equities is still intact. This is an important distinction because every sustained drop in U.S. equities has been accompanied by a recession and we are confident that that will not occur in 2018, so there is a market floor and an interim window for gains. The market (for now) is supported by the positive headline narrative of U.S. tax reform that, by all estimates, will lead to a temporary boost in both U.S. GDP in 2018, estimated at 2.7% by the CBO and IMF, and U.S. corporate earnings growth that is estimated at 20% for the S&P 500 Index.
Historically, corporate M&A has peaked in the late-stage of economic expansions, as companies act to lock-in low borrowing costs, and we have every reason to expect the same scenario to emerge in 2018, particularly after volumes fell by 9% in 2017. That should support our event driven strategy and the 15-equity positions in the fund Portfolio at the end of Q1 2018, including Sky Plc and Time Warner Inc. that have both received buyout offers. We expect the estimated $1 trillion of repatriated capital to drive increased M&A activity in the technology sector, where we have invested in Yelp, Inc., an attractive acquisition target with a first-mover advantage in local advertising. Consolidation is also expected in the paint sector, where we are invested in Nippon Paint Holdings Co., the #1 Asian manufacturer and #4 globally, and the satellite sector, where we have a position in Inmarsat plc.
Lower valuations and higher growth prospects have generally led us to favor international markets, which represent 65% of Portfolio holdings. We particularly like companies catering to China’s middle class of 350 million people, including New Zealand-based infant formula maker, A2 Milk Co. Ltd., Diageo Plc, and Audi AG, which owns 100% of Lamborghini and Ducati. Other international investments are driven by growth in online/mobile commerce, including Just Eat Holdings Ltd., Kerry Logistics Network, Thomas Cook Group plc, and Yandex NV. Our domestic U.S. investments are notably limited to companies with large share buyback programs, including Alphabet, Inc., Altaba, Inc., and Dolby Laboratories. We expect share buybacks to represent an important source of net share demand in the U.S., where the heavy ETF concentration (estimated at +30% for the S&P 500) means investors must ‘sell the entire market’ simply to diversify.
The bad news will arrive next year, in our view, when there is a reversion to the mean and the one-time lift to corporate earnings fades, as higher borrowing costs erode gains afforded by recent tax cuts. That is our rationale for holding 8% of the fund Portfolio in cash and 7% in gold. We believe fundamentals are sound today, but only because interest rates are still relatively low. To borrow from Chairman Powell, “important longer-run challenges,” are likely to limit trend growth to just 1.8% per annum (p.a.). After all, GDP is driven by a combination of (i) labor force growth that will fall to 0.5% p.a. in the next decade and (ii) productivity increases that have grown by 0.9% p.a. over the last decade, which is well-below the 2% p.a. gains of the 1990s and the hopeful forecasts of the CBO, which expects productivity increases of 1.4% p.a. in the next decade.
The current bull-market has been propelled by (i) low bond yields, (ii) job growth and (iii) the rise of electronic trading funds (ETFs). If the first two legs are lost, we will be left sitting on the third-leg of the stool, a terrifying prospect. ETFs have changed the hard-wiring of the markets, in our view, and will accelerate the downturn, as investors rush to sell the same securities in unison. When the current streak of job gains (now at 90 consecutive months) reverses itself, a sounding-alarm for recession, we expect a precipitous decline in U.S. equities that will fall +40%, if price/earnings multiples contract to 10.5x, the bottom-level in March 2009. Recent investor losses in ETFs pegged to the volatility index (or VIX), which lost 94% of their value in one day on February 5th, provide a window into the damage that will occur, when confidence is lost. Let’s not forget, the $3 billion of ETF losses that day occurred on a good one, when global growth is expected to increase 4.1% in 2018.
We believe there are times to make money and other occasions when the focus should be on capital preservation. Our focus is now shifting to the latter. The window for equity gains is narrowing and – make no mistake – there won’t be any place to hide, when the tide rolls out. We all like beach vacations, but it always pays to base your travel on local weather patterns and what you’re hearing here is that conditions look unseasonably awful in your favorite holiday spot next year, so it’s time for a new plan. If it helps to visualize, pretend you are looking at a flashing yellow light that you know will turn red next year. At this stage in the cycle, any additional equity upside rests on what John Kenneth Galbraith dubbed the “vested interest in euphoria.” Instead, we are choosing to lean-on the words of famed-investor Bernard Baruch, who explained: “I made my money by selling too soon.”
[1] Hatzius, Jan. “A Stress Test for Higher Rates,” Goldman Sachs Research, February 24, 2018.
[2] “China Weighs Slowing or Halting Purchases of U.S. Treasuries.” Bloomberg News, January 10, 2018.
[3] Earnings before interest, taxes, depreciation and amortization (EBITDA) is used as a proxy for cash flow.
[4] International Monetary Fund, Global Financial Stability Report, April 2017, pg. 13.