policy based investing · policy based investing september 14, 2020 swap spreads are the extra...

POLICY BASED INVESTING September 14, 2020

SPREAD ANALYSIS

Sometimes we come across a piece of research so good that we share it in its entirety. Today is one of those times. Here's an excellent analysis of bond market spreads written by our friend Scott Grannis. Scott is one of the best in the business. We take his thinking very seriously, and you should too. Bottom line: Lots of reasons for economic optimism.

Spread monitor: looking good - By Scott Grannis

Often, prices alone cannot tell the story. Knowing a stock has gone up 10% is nice, but if that happens in the context of the broad market rising 20% then it's not so nice. In the bond market, comparing one yield to another is essential to understanding value. Virtually every bond in the world is priced relative to Treasuries of comparable duration or maturity. The Treasury yield curve is the "backbone" of all yield curves; it sets the gold standard for yields of all maturities because Treasuries are the most liquid, risk-free securities in the world. Without the Treasury yield as a universal benchmark, the bond market would be much less efficient.

Looking at the "spread," or difference between the yield on, say, a corporate and a Treasury bond of similar maturity is essential to understanding the value of that bond, which in turn depends on how risky the market perceives its issuer to be. The greater the spread, the riskier, and the smaller the spread, the safer. Spreads can also tell us about the health and underlying liquidity conditions of the market as a whole. And by inference, spreads can also tell us about what the outlook is for the economy, since a healthy financial market is essential to a healthy economy.

The following charts cover the spreads I consider essential to understand the economic and financial fundamentals. Fortunately, they are all telling a good story.


Chart #1 looks at the "TED" spread, which is the difference between the yield on 3-mo. LIBOR securities and 3-mo. T-bills. (The acronym TED comes from Treasury vs EuroDollar.) LIBOR is a standardized measure of short-term yields of dollar-denominated securities which trade overseas in what is commonly referred to as the eurodollar market. The TED spread is equivalent to the extra yield over risk-free T-bills that investors require to accept the credit risk of a major overseas bank, since it is those banks that pay LIBOR when they borrow. Long story short, the TED spread is a good proxy for how risky the global banking system is. Current spreads are about 15 bps, which is the difference between the 25 bps yield on 3-mo. LIBOR and the 10 bps yield on 3-mo. T-bills. That's about as low as the TED spread has ever been, and that's a very good thing, because it means global financial markets are in very good shape.


Swap spreads are the extra yield that investors require to enter into a swap agreement with a major broker-dealer or financial institution. Swap agreements involve one party paying, for example, a fixed rate to another party and accepting a floating rate in return. Swap transactions effectively allow investors and financial institutions to efficiently manage their risk. You can find a longer explanation of swap spreads here.

Chart #2 looks at 2-yr swap spreads, which is the extra yield that one party requires in order to enter into an agreement in which the investor receives a floating yield in exchange for paying a fixed, 2-yr yield. 2-yr swaps represent a highly liquid market and are thus an excellent proxy not only for the health of financial markets but also the general liquidity conditions of financial markets (a high degree of liquidity leads to very low spreads). Current swap spreads in the US are very low, while spreads in the Eurozone have clearly moved into "healthy" territory after spending many years in not-so-healthy territory.

Bottom line: swap spreads tell us that global financial markets are in very good shape, and that can often be a good predictor of future economic health. They also tells us that central banks for the most part are not a threat to the markets or the economy. No one is being starved for liquidity, and real interest rates (and thus borrowing costs) are extremely low. Note also that this predictive ability of swap spreads can be seen in Chart #2, as swap spreads rose in advance of the 2008 recession and fell in advance of the recovery.


Chart #3 shows 5-yr Credit Default Swap spreads. CDS spreads are a very liquid market that gives a good proxy for 5-yr corporate credit risk. Spreads are trading at pretty low levels, suggesting that credit risk is minimal, and by extension, that investors perceive the outlook for the economy to be healthy.

Chart #4 shows the difference between investment grade and high yield CDS spreads, something that is called the "junk spread." This too is a good proxy for the extra risk an investor experiences as he or she ventures into the junk bond arena.


Chart #5 is an amalgamation of the credit spreads on two classes of corporate bonds of all maturities—and there are many. Here again we see that spreads are generally low, thus the implied outlook for the economy is healthy. Investors are not overly concerned about the outlook for corporate profits.

Charts #6 and #7 show the spreads between nominal and real yields on Treasuries and TIPS (TIPS = Treasury Inflation Protected Securities). This difference, or spread, is equivalent to the market's expectation for future annual inflation rates. In both cases, it appears the market is expecting consumer price inflation to average just over 1.5% per year for the foreseeable future. If this proves to be an accurate forecast I—and most people—will be happy. I worry, however, that the Fed wants the inflation rate to be higher, and I've learned to never doubt the Fed's ability to get what it wants.

It's important to realize that most people's understanding of how inflation works is faulty. Inflation is not a by-product of strong growth or strong demand. Inflation happens when there is more money in the system than people want to hold. Inflation lies in the intersection of a central bank's willingness to supply money


and the public's desire to willingly hold that money. Too much money is what leads to inflation. There is certainly plenty of money these days, as I have documented in prior posts. What is keeping inflation in check is the apparent fact that the public is happy to hold all that money, because there are still many things to worry about and money provides security.

What we need to be attentive to is the return of confidence, since that will act to reduce the demand for money. And if the Fed doesn't react to this by increasing short-term rates in a timely fashion, we will end up with higher-than-expected inflation and eventually much higher interest rates as the Fed is forced to tighten monetary conditions. This is how almost every recession (except this year's) has started, by the way, so it's not a pleasant prospect. Fortunately I don't see this happening any time soon, but next year is still out there on the horizon....


ALLOCATOR

Fixed Income

Bonds are an asset class that does well in a deflationary policy environment (Low Growth & Strong Currency)

We have long said the Treasury bond bubble will pop again as it did from May2013-Jan2014 when long term Treasury bonds fell 18%. With voters choosing Trump’s pro-growth agenda to ignite growth, we believe the this is even more likely. Treasury bond prices are at risk to fall 30-50%, and we expect any moves higher in bond prices (lower in yields) to be short-lived. Since most other bonds price off of Treasury yields, fixed income in general is a risky asset class.

Asset ETF Action Date Red Sell/Green Buy

Current Price

% Gain/Loss Policy Notes

Investment Grade LQD 9/9/2016 $119.00 $135.37 13.8%

Aggregate Bond AGG 9/9/2016 $109.00 $118.37 8.6%

Municipal MUB 9/9/2016 $111.00 $115.94 4.5%

TIPS TIP 9/9/2016 $114.00 $126.50 11.0%

Extended Duration EDV 9/9/2016 $128.00 $167.44 30.8%

US Treasury 3-7 yr IEI 9/9/2016 $124.00 $133.68 7.8%

US Treasury 7-10 yr IEF 9/9/2016 $109.00 $122.01 11.9%

US Treasury 20+ yr TLT 9/9/2016 $133.00 $164.48 23.7%

International Total Bond BNDX 9/9/2016 $54.40 $58.07 6.7%

High Yield HYG 4/12/2016 $77.00 $84.45 9.7% Act more like equities than bonds, benefit from improving growth


ALLOCATOR

Commodities

A change in the price of gold is a change in the value of the currency. When gold rises, the currency’s value falls and vice versa. Commodities are an asset class that does well when the currency is weak. If growth is slowing while the currency weakens, there is stagflation. Own precious metals. If growth is accelerating while the currency weakens, there is an inflationary expansion. Own agriculture, industrial and energy commodities.

Commodities suffered heavy losses in the strong US Dollar environment 2012-2015. In 2016 Dollar weakness was caused by election uncertainty and commodities rallied. That weak Dollar trend was reversed by Election2016.

Gold’s recent rise has been driven by a general “risk-off” stance, caused in large part by fear about coronavirus impact on global trade/supply chains coupled with DNC rising odds to capture the 2020 Presidential Election. We expect these fears to be transitory throughout 2020, especially since we do no believe Sanders’ policy menu can win the country. At this time the move up in gold is not, in our assessment, connected to worsening domestic economic policies that would cause a flight out of Dollars. However, we cannot ignore the market based signal of gold moving to new highs.


Current Price % Gain/Loss Policy Notes

Gold GLD 2/18/2020 $150.91 $182.45 20.9% Safe haven rush into precious metal

Silver SLV 2/18/2020 $17.01 $24.90 46.4%

Energy DBE 8/13/2014 $28.97 $9.21 -68.2%

Oil USO 7/30/2014 $37.00 $27.04 -26.9%

Agriculture DBA 9/13/2011 $32.50 $14.86 -54.3%

Broad Comm. Index GSG 8/5/2011 $33.00 $10.57 -68.0%

Base Metals DBB 6/17/2011 $23.00 $15.42 -33.0%


ALLOCATOR

Real Estate

Real Estate is an asset class that performs well when growth is accelerating. When rising growth is coupled with a strong currency, own real estate tied to business activity (like commercial REITS). When rising growth is coupled with a weak currency, own real estate tied to commodities (farmland).

Commercial RE will be helped by improving real economic growth. RE properties leveraged to businesses & economic growth are preferred under pro-growth US policies.


Current Price

% Gain/Loss

Policy Notes

Residential REZ 12/21/2016 $61.00 $62.82 3.0%

Building/Construction ITB 12/21/2016 $28.00 $54.89 96.0%

Mortgage REIT REM 4/1/2016 $35.00 $26.14 -25.3%

REIT VNQ 3/7/2016 $75.50 $80.25 6.3%


ALLOCATOR

US Equity

US Equity - Cap Size

We have been waiting for a 1980s/90s type of policy driven equity bull market for sixteen years. The 2014 midterm House/Senate/gubernatorial election shifts put us on the path as pro-growth candidates propelled the GOP to majorities. It was a repudiation of anti-growth economic policies and a big step toward a Reagan/Clinton type of equity bull market. Despite the voters’ growth signal, Obama doubled down on his tax/spend/regulatory (EPA) agendas in 2015 causing stocks to be range bound and volatile. As 2016 began, policy uncertainty ahead of November’s elections became the biggest threat to equities. The ebb and flow of the presidential political season moved markets in both directions as investors waited to learn which policy theme would prevail in November – growth vs. redistribution. Voters decisively made their choice in Election2016, and growth won. Trump’s pro-growth policy agenda beat Hillary’s anti-growth policy agenda in landslide fashion. Republicans retained control of the Senate, House and increased their control of governorships by three. The policy stage is now set for Trump and Congress to keep delivering pro-growth tax, regulatory and monetary policies. As they do, a bull market in U.S. equities will ignite to rival the 1980s/90s


Current Price % Gain/Loss Policy Notes

Micro IWC 7/11/2016 $72.00 $90.25 25.3%

Total Market IWV 5/19/2016 $117.00 $194.64 66.4%

Large IWB 5/19/2016 $111.00 $185.78 67.4%

Small Cap IJR 5/19/2016 $54.00 $70.98 31.4%

Mid Cap IWR 4/6/2016 $38.57 $56.81 47.3%


US Equity - Style

US Equity - Sector


Current Price


Large Growth IWF 7/11/2016 $101.00 $211.55 109.5%

Small Growth IWO 7/11/2016 $140.00 $215.43 53.9%

Small Value IWN 5/19/2016 $92.00 $101.56 10.4%

Mid Growth IWP 5/9/2016 $90.00 $164.41 82.7%

Large Value IWD 4/6/2016 $95.00 $119.61 25.9%

Mid Value IWS 4/6/2016 $68.00 $81.82 20.3%


Current Price


Staples XLP 6/5/2017 $57.00 $64.65 13.4%

Utilities XLU 6/5/2017 $54.00 $58.93 9.1%

Metals/Mining XME 5/8/2017 $29.00 $23.96 -17.4% Tied to commodity prices, hurt by strong Dollar

Energy XLE 3/13/2017 $69.00 $32.62 -52.7% Tied to commodity prices, hurt by strong Dollar

Healthcare XLV 2/8/2017 $71.00 $104.59 47.3%

Discretionary XLY 11/14/2016 $79.00 $146.07 84.9%

Financial XLF 7/18/2016 $19.00 $24.71 30.1% Helped by Trump deregulation (Dodd Frank)

Materials XLB 4/6/2016 $44.00 $65.07 47.9%

Industrial XLI 3/14/2016 $52.00 $77.61 49.3%

Technology XLK 3/7/2016 $41.00 $112.96 175.5% Repatriation tax reform huge plus for tech companies


Foreign Equity

Country ETF Action Date Red Sell/Green Buy

Current Price


China FXI 8/5/2019 $39.86 $42.55 6.75% China’s currency devaluation policy is a growth killer

Hong Kong EWH 7/6/2016 $24.08 $22.42 -6.89%

Mexico EWW 10/1/2018 $51.23 $33.56 -34.49% Freer and fairer trade agreements are pro-growth for all parties involved

Canada EWC 10/1/2018 $28.78 $27.88 -3.13%

Denmark EDEN 7/2/2018 $63.89 $83.01 29.93% European polices not improvng despite anti-austerity movements across the Euro Zone. Capital is fleeing. A zero trariff trade deal

with the U.S. would reverse course and be very pro-growth for European economies.

Switzerland EWL 7/2/2018 $32.58 $42.25 29.68%

Netherlands EWN 7/2/2018 $30.51 $35.22 15.44%

Sweden EWD 7/2/2018 $30.51 $35.51 16.39%

Eurozone EZU 7/2/2018 $41.01 $39.44 -3.83%

Spain EWP 7/2/2018 $30.35 $22.80 -24.88%

Poland EPOL 7/2/2018 $21.78 $17.39 -20.16%

France EWQ 7/2/2018 $30.52 $29.40 -3.67%

Germany EWG 7/2/2018 $29.98 $30.31 1.10%

Italy EWI 7/2/2018 $28.89 $25.66 -11.18%

Austria EWO 7/2/2018 $22.65 $15.56 -31.30%

Israel EIS 2/26/2018 $52.41 $50.95 -2.79%

Vietnam VNM 10/9/2017 $14.99 $14.79 -1.33% Demographic leverage to US economic growth policies

Indonesia EIDO 7/24/2017 $26.78 $17.81 -33.50% Demographic leverage to US economic growth policies

Ireland EIRL 1/26/2017 $39.00 $41.00 5.13%

Singapore EWS 1/11/2017 $21.00 $18.67 -11.10%

World Ex US VEU 11/15/2016 $43.50 $51.35 18.05% Global growth reset higher after US Election2016

Norway ENOR 8/20/2016 $20.00 $21.54 7.70%

UK EWU 8/4/2016 $30.50 $25.99 -14.79% Brexit was a vote for growth


Finland EFNL 7/26/2016 $33.00 $40.57 22.94%

Japan EWJ 7/15/2016 $47.00 $58.55 24.57% Trade deal with U.S. is pro-growth

South Korea EWY 7/13/2016 $52.00 $64.50 24.04%

Hong Kong EWH 7/6/2016 $19.00 $22.42 18.00%

Peru EPU 6/29/2016 $30.50 $30.06 -1.44%

South Africa EZA 6/29/2016 $51.00 $38.27 -24.96%

India EPI 6/27/2016 $19.00 $23.68 24.63% Strong Dollar emerging market, tied to US growth

Taiwan EWT 6/21/2016 $27.00 $44.35 64.26%

Thailand THD 5/20/2016 $64.00 $65.85 2.89%

Belgium EWK 3/16/2016 $16.50 $17.56 6.42%

New Zealand ENZL 3/5/2016 $36.00 $58.25 61.81%

Philippines EPHE 8/5/2015 $37.00 $26.76 -27.68%

Qatar QAT 12/1/2014 $24.00 $17.43 -27.39%

Malysia EWM 10/3/2014 $41.00 $25.59 -37.59%

Australia EWA 9/16/2014 $22.50 $20.15 -10.44%

Greece GREK 7/14/2014 $20.00 $20.65 3.25%

Portugal PGAL 6/4/2014 $15.00 $9.66 -35.60%

Columbia ICOL 6/27/2013 $21.00 $8.90 -57.62%

Turkey TUR 6/1/2013 $58.00 $20.15 -65.26%

UAE UAE 5/20/2013 $23.00 $10.84 -52.87%

Russia RSX 8/7/2011 $30.00 $19.97 -33.43% Weak Dollar emerging market

Brazil EWZ 7/14/2011 $60.00 $30.09 -49.85% Weak Dollar emerging market

Chile ECH 3/1/2011 $61.00 $25.11 -58.84%

Egypt EGPT 2/23/2004 $64.00 $24.93 -61.05%


POLICY MAP

Growth increased versus last week (0.64 to 0.88) : Growth expectations have moved back into positive territory on expectations that anti-growth policies will not result from Election 2020. The Fed is providing unlimited liquidity to prevent a solvency crisis during the first even intentional recession in history.

Value of US$ unchanged versus last week (2.59 to 2.59): Dollar had been stable between gold $1,300-$1,375/oz, and strengthened to $1,230/oz. giving the Fed a strong Dollar signal to pause rate hikes until economic and market data calm down. Recent Dollar weakness above $1,400 is concerning but likely has some likely temporary drivers like Coronavirus and threat of an anti-growth DNC policy agenda post 2020. The longer the U.S. economy remains shut down, the weaker the U.S. will become.


BOND YIELD COMPONENT ANALYSIS

Nominal Yield: 0.67% (-7%) Inflation Expectation Component: 1.65% (-3%) Real Growth Component: -0.98% (+3%)

Bond market expectations for both real growth and inflation have collapsed. Before recently, the collapse in real growth had been largely caused by global bond market dynamics with negative interest rates across the globe. But now slow growth fears have come to the U.S. A domestic “shutdown” caused by COVID-19 weighs heavily on near term growth. Economic slowdown, even if it’s short, makes post-2020 election policy highly uncertain. The Federal Reserve is doing what it needs to do by providing sufficient liquidity to the banking system. Fiscal policy is the next policy lever to be pulled to counteract negative economic effects of a COVID-19 caused economic shutdown, and the payroll tax holiday is an excellent first step.

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policy based investing · policy based investing september 14, 2020 swap spreads are the extra...

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