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When JPM quant Marko Kolanovic released his latest report today, we were expecting him to read his latest insight on the positioning of quant funds, on the relative imbalance of risk parity, or perhaps whether market gamma was suggesting that the market is poised for an inflection point, either lower or higher. Instead, we were surprised to read an extended analysis looking at how trapped the “out of options” central banks are, what the next steps are for the global economy, how the market is now as overvalued as it was before the 2000 crash, how rising rates “would make the current S&P 500 level look like a bubble”, and the exhaustion of all available policy options, which he dubbed the “endgame.” To wit:

If investors lose confidence that the debt can ever be repaid, they will reduce their holdings, increasing the cost to governments or inviting more central bank buying. This can eventually result in the devaluation of all currencies against real assets such as gold, high inflation or even outright defaults (as was the case in Greece). If such a trend develops in one of the large economies, it could have far-reaching consequences.

We were most surprised by Kolanovic’s strong case to buy gold, although considering it comes just one week after a Pimco economist dared to propose that central banks should monetize gold next in an attempt to massively boost inflation expectations (while send the price of gold to $5,000), perhaps we are not that surprised.

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We are confident readers will find it just as an engaging read.

From JPM’s Marko Kolanovic

Central banks, Inflation, and Debt Endgame

With the Fed and BoJ meetings behind us, markets are increasingly accepting that central banks are nearly out of options. Central banks can hardly raise interest rates, and there is a growing realization that negative interest rates simply make no sense (see analysis below). Unconventional approaches of buying corporate bonds (ECB) and stocks (Japan) so far have not produced significant results, and run the risk of tainting these assets for private investors. The next attempt to boost the economy or prevent a potential market crisis will likely need to be accomplished by fiscal measures. Fiscal measures may be employed even if there is no crisis (e.g., post US election), and over the next months investors will look closely at potential measures and their impact on equity markets, commodities (potential positive impact on certain sectors – e.g., from infrastructure spending), and the value of debt and currencies (likely negative impact).

Before we discuss the implications and risks that could result from such developments, we present an analysis that suggests that central banks face the risk of entrenched low inflation (rather than the risk of high inflation) and likely will not be able to raise rates meaningfully. Figure 1 shows the cumulative PCE (relative to the Fed’s 2% target) that shows significant and persistent undershooting over the past 8 years. Since 2000, the cumulative undershoot is 6% on the core PCE measure. Over the past 4 years, core PCE undershot by more than 1.5 % (and headline by 3.5%, the difference being largely due to the 2014 decline in energy). This undershooting is fairly significant: over the past 2 years headline PCE undershot by 3% (2 standard deviations) and Core by 1% (1 standard deviation). What should be more worrying is that PCE readings historically show strong persistence (serial correlations). This means that a low core PCE reading today implies that PCE is more likely to stay low in the future as well (e.g., core PCE reading today has 80% correlation with the reading of 12 months ago). Our quantitative model of core PCE indicates the most likely level is still below the Fed’s 2% target and continuing to undershoot over the next 3 years.

In that context, the Fed should welcome any overshooting of the target as that is the only way it can end up closer to the stated 2% target over any meaningful time period (e.g., 2, 5, or 10 years). For instance, overshooting the target over the next 2-3 years by ~0.5% each year (or over the next 1-2 years by ~1%) would put the inflation averages within the margin of the stated 2% target. The problem is that it simply may not happen, and inflation breakeven rates in the US, Europe and Japan point to the same direction.

Over the past 20 years, PCE overshoots (undershoots) tended to coincide with S&P 500 rallies (declines). However, over the past 8 years, PCE kept trending lower, while the market rallied strongly. While the Fed’s QE programs did not prevent inflation to persistently undershoot the 2% target, a potential byproduct was inflated S&P 500 valuations. Indeed, many clients ask us how much of the S&P 500 rally can be attributed to near zero rates and can be at risk should rates continue to rise? Assuming the S&P 500 returning to median P/E levels for comparable rate and inflation environments in the past, it would suggest a 5%-15% de-rating of the equity multiple should rates continue to rise at a moderate pace and assuming no increase of recession probability. If rates increase the probability of recession, it would likely result in a larger market pullback, as both earnings and multiples would suffer.

Should the problem of low inflation go away (e.g., if there is an oil price shock, or upside growth surprise) and there is need to raise rates more significantly, the Fed will face another problem. That is how to hike but not push the equity market significantly lower. The reason is that with current levels of leverage, rates behave like a ratchet (easy to turn lower, but hard to turn higher without breaking the gears). Over the years of ZIRP, asset prices and business models adjusted to low rates. For example, home buyers make decisions based on monthly mortgage payment levels, and S&P 500 companies (ex-financials) have the highest leverage since 2007 (when leverage was at record levels), with some of the debt used to buy back shares.

Indeed, the current S&P 500 P/EBITDA ratio is at the same level as shortly before the market crash of 2000. The distinction between current market valuations being reasonable vs. bubble-like is due to low interest rates (as well as lower effective tax rates). Significant increase of rates (e.g., to levels implied by 2018 Fed dots) would make the current S&P 500 level look like a bubble.

As we argued above, it is hard to see short-term rates moving meaningfully higher any time soon. We also think that rates cannot go much lower either as negative rates fundamentally don’t make sense (issues such as physical storage of cash can make negative yields viable only over short periods of time). So the attempt to boost growth or fight a potential crisis will likely need to be accomplished by fiscal measures.

However, fiscal measures also bring an increased level of government debt and increased market and credit risk of owning government bonds. These risks are in addition to current low yields and a less favorable correlation of bonds to risky assets. The unfavorable risk-reward of government bonds near the point of zero yields will likely prevent asset managers from increasing holdings of government bonds. If there are no private buyers, governments can still place their bonds with central banks. This trend is of course already in place – for instance, the Fed’s holdings of US Treasuries increased from ~18% in 2008 to ~34% today.

Increased government spending, financed by central banks could indeed create inflation, but will further elevate the problem of debt viability. If investors lose confidence that the debt can ever be repaid, they will reduce their holdings, increasing the cost to governments or inviting more central bank buying. This can eventually result in the devaluation of all currencies against real assets such as gold, high inflation or even outright defaults (as was the case in Greece). If such a trend develops in one of the large economies, it could have far-reaching consequences.

Once fiscal measures replace monetary measures, we think investors will increasingly focus on the dynamics of government debt and currency valuations, particularly in Japan and the US.

How can an investor hedge against the risk of these potential developments? One can reduce allocation to bonds and increase allocation to real assets and equity sectors related to real assets. Investors can also move away from bonds that are not backed by reserve assets such as currency reserves or gold. The ability of a government to pay back debt and at the same time as maintaining the value of the currency should be measured by hard assets for which transfer to bondholders is politically viable. For example, during the Greek crisis, the option of selling islands owned by the government was off limits. On the other hand, governments can easily part with assets with no national or cultural attachments such as FX reserves or gold, as was recently the case with Ukraine and Venezuela.

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