A Scramble for Capital

A Spike in Bank Lending to Corporations – Sign of a Dying Boom?

As we have mentioned on several occasions in these pages, when a boom nears its end, one often sees a sudden scramble for capital. This happens when investors and companies that have invested in large-scale long-term projects in the higher stages of the production structure suddenly realize that capital may not be as plentiful as they have previously assumed. The wake-up call usually involves a surge in market interest rates and subtle shifts in relative prices in  the economy (consider for instance the recent decline in new home prices amid declining sales). Interest rates have certainly provided a signal lately:

Short term USD interest rates: 2-year treasury note yield, 3-month t-bill discount rate and LIBOR (USD interbank lending rate in London, used as a benchmark for rate adjustments of countless bonds, loans, swaps, derivatives, etc.).

We last mentioned this phenomenon in a money supply update in May in connection with the then nascent rebound in commercial and industrial lending, which has accelerated a bit further in the meantime. Superficially this rebound cannot be differentiated from other surges in credit demand, but there are many strong hints supporting the idea that it is indeed the typical late stage boom phenomenon. Apart from rising short term rates these inter alia include a rapidly flattening yield curve, rising price inflation and very low initial unemployment claims.

Historically this scramble for credit in the late stages of a boom could be observed on numerous occasions. It was particularly pronounced in 2007-2008, when in addition to recognizing the intensifying scarcity of capital, companies began to fear that banks might decide to cut their unused credit lines just as other avenues of obtaining external financing were closing down. They proceeded to draw down such credit lines as quickly as possible. Looking solely at the jump in commercial & industrial loans (C&I loans) at the time, one would probably not have guessed that a major bust had just begun.

Our friend Michael Pollaro, whose update on the tipping point in outstanding Fed credit we recently discussed, decided to take a closer look at this signal. What he has found is quite interesting and fits well with the idea. Namely, a sudden surge in C&I lending can be identified as a warning signal when it happens at the tail end of a noteworthy decline in the growth rate of the broad true US money supply (TMS-2). Here is a chart that illustrates the situation: 

Year-on-year percentage growth in TMS-2 (yellow area) vs. y/y percentage growth in C&I loans (blue line).

Admittedly the signal is hardly the most perfect timing device, but an overlay chart with the S&P 500 Index suggests it has some use from a medium to longer-term perspective. There were two clearly discernible C&I lending spikes close to both the year 2000 and 2007 peaks. Both started before the peak, but the one in 2007 continued for a while longer. Not surprisingly, these spikes were then followed by sharp reversals in loan growth amid noticeable market declines and worsening recessionary conditions.

Year-on-year percentage growth in C&I loans (light blue area) vs. the SPX (dark blue line).

The most recent spike in C&I loans has begun from a much lower level than its immediate predecessors, but we don't believe this makes it any less valid as a signal. Rather, we think it is an indication that corporate bond markets have become tighter. Evidence from surveys suggests that credit investors are becoming more selective lately, insisting on stricter covenants, higher yields and shorter terms to maturity.

As we have pointed out previously, QE by central banks in combination with stricter capital requirements for banks (Basel III and the swarm of new regulatory acronyms it has given birth to) have led to a shift in corporate borrowing, with bonds, promissory notes and leveraged loans bought by investors partly replacing traditional bank loans.

Still a Distorted Production Structure

It should be noted that there is currently a to-and-fro between the major contingent circumstances surrounding the tightening monetary backdrop. On the positive side, we have the US president making good on his promises with respect to tax cuts and cutting back regulations – which incidentally puts pressure on other countries to follow suit, so it does not only help US citizens, but indirectly may have positive effects elsewhere as well.

On the negative side, we have the US president making good on his promises with respect to trade restrictions, while increasing the federal deficit by leaps and bounds. Both are a burden on the economy, but there is still some hope that his ultimate goal is to use tariffs only temporarily in a kind of stick and carrot approach designed to get other countries to agree to rescind their trade barriers, with the US ostensibly prepared to reciprocate.

Nevertheless, the vast expansion in the money supply over the past decade, the enormous debt accumulation it has triggered and the associated capital malinvestment cannot be wished away. Trends in sentiment based on contingent events may influence the timing of the necessary adjustment, but they cannot prevent it. Below is an updated chart of the ratio of capital to consumer goods production:

 

The ratio of capital to consumer goods production shows that during credit expansions, more and more investment is drawn toward the higher stages of the production structure (capital goods, long-term investments) relative to the lower stages (goods and services close to consumption). There is nothing wrong with this when it happens on account of rising savings, but when it happens due to money printing and interest rate manipulation, it is a safe bet that a lot of capital is malinvested and ultimately consumed. When interest rates return to levels more in tune with actual time preferences, they signal that there is far less capital available than previously thought. A bust happens when the capital structure is perforce rearranged to reflect a more sustainable production/consumption ratio. This is why declines in the above ratio are aligned with recessions. Sometimes busts remain confined to a few sectors and don't push the entire economy into a technical recession – the oil patch bust of late 2014-early 2016 is an example. These mini busts will still be visible in the ratio, and the economy at large will exhibit very weak and uneven growth.

Obviously, the ratio remains quite elevated – it is still near the level at which it peaked in 2007. The interventions of major central banks in recent years have created a unique situation, which makes it even more difficult to forecast the timing of an eventual bust than it normally is. What is clear though is that we continue to get subtle early warning signs.

 

Easy credit galore – and much of it will have to be refinanced quite soon.

We suspect many creditors will come to rue their boom time generosity.

J. Hussman On FAANGs: "This Movie Has Played Out So Many Times, We've Memorized The Lines"

...Notes on exponential revenue growth

While we're on the subject of extrapolation and speculative valuations, it may be useful to address the primary driver of market strength in recent weeks – the FAANG group comprised of Facebook, Apple, Amazon, Netflix, and Alphabet (renamed from Google). From a near-term perspective, this advance has many of the features of a "short-squeeze" – in particular, the advances tend to be "jump" advances on rather light volume, as sellers back away at the same time that short investors attempt to cover by chasing the stocks higher. Still, it's the long-term perspective that's particularly interesting here.

We've always emphasized that stocks are a claim on the very long-term stream of cash flows that they will deliver to investors over time. When companies are growing very quickly, investors tend to look backward, and as a result, they often apply very high rates of expected growth to already mature companies. When valuations are already elevated, this practice can be disastrous, as investors discovered in the 2000-2002 collapse that followed the tech bubble.

On this subject, it's notable that Apple's revenue growth rate has slowed to an average rate of less than 4% annually over the past three years. As I detailed a few years ago,"Despite great near-term prospects, within a small number of years, Apple will have to maintain an extraordinarily high rate of new adoption if replacement rates wane, simply to avoid becoming a no-growth company. That's not a criticism of Apple, it's just a standard feature of growth companies as their market share expands."

The tendency for growth to slow as company size increases is sometimes called the "law of large numbers." This is excruciating for anyone who knows statistics, because the law of large numbers actually describes the tendency of the sample average to approach the population average as sample size increases. What people really mean is "logistic growth" – which is the tendency of growth to slow as the size of a system approaches its mature "carrying capacity." For any logistic process, the growth rate slows as size increases, steadily falling in proportion to the amount of remaining capacity in the system.

Leading companies in emerging industries can experience spectacular growth rates because of the compound effect of rising market share in a growing sector. Let an emerging industry start from a tiny base, and grow at 30% annually for a decade, while a leading company moves from a 10% market share to a 50% market share. The company will enjoy a 10-year growth rate of 52.7% annually. But as companies become dominant players in mature sectors, their growth slows enormously. Let that mature industry double over a decade, while the company's market share slips from 50% to 40%, and the 10-year growth rate of the company slows to just 4.8% annually.

Investors should, but rarely do, anticipate the enormous growth deceleration that occurs once tiny companies in emerging industries become behemoths in mature industries.You can't just look backward and extrapolate. In the coming years, investors should expect the revenue growth of the FAANG group to deteriorate toward a nominal growth rate of less than 10%, and gradually toward 4%.

The chart below shows the general process at work, reflecting the relationship between market saturation and subsequent revenue growth. Here, the points are plotted based on revenue at each date as a percentage of 2018 trailing 12-month revenues. The vertical axis shows annual revenue growth over the subsequent 2-year period. Clearly, Apple is the furthest along in terms of saturation.

Growth rates are always a declining function of market penetration.

Remember that the latest point on this chart for each company is two years ago. For all of these companies, current revenues represent the far right of the graph, and the corresponding value for subsequent growth will be available 2 years from now. Again, my expectation is that most of those growth rates will slow toward 10%, and gradually toward about 4%(which reflects the structural growth rate that can be expected for U.S. nominal GDP when one assumes a moderate pickup in productivity, inflation slightly over 2%, baked-in-the-cake demographics like population growth, and limited scope for a further cyclical decline in the rate of unemployment).

Below, I've embedded some analysis about the dynamics of growth from a few years ago. I expect that these considerations will become increasingly relevant for the entire FAANG group in the years ahead.

Consider a very large, untapped market for some product. We can model the growth process in terms of how quickly that product is adopted by new users, whether there are any "network" effects where new buyers are attracted to the product because other people already use it, how frequently existing users replace their products, whether late-adopters come in more slowly than early-adopters because of budget constraints, how quickly the untapped market grows, and a variety of other factors.

Whether you do this sort of modeling with a spreadsheet or with differential equations, you'll get essentially the same results. Specifically, growth rates are always a declining function of market penetration. Most strikingly, the growth rates begin to come down hard even at the point that a company hits 20-30% market penetration. Network effects accelerate the early growth, but also cause growth to hit the wall more abruptly. Replacement helps to accelerate the early growth rates too, but ultimately has much more effect on the sustainable level of sales than it has on long-term growth. In fact, if the replacement rate (the percentage of existing users that replace their product each year) is less than the adoption rate (the percentage of untapped prospects that are converted to new users), it's very hard to keep the growth rate of sales from falling below the rate of economic growth.

The chart below gives the general picture of various growth curves and the effect that different factors can exert. The paths are less important for their actual growth rates as they are for their general profiles (below, I've assumed that 15% of the untapped market adopts the product each period). It may seem odd that you could get a growth rate below the adoption rate. But notice that with an adoption rate of 15% and a total potential market of 1000 units, for example, you'll sell 150 units the first year, but the next year's sales will only be 15% of the 850 remaining untapped prospects, so growth will actually be negative unless you have other factors contributing, such as discovery, replacement, network effects, and so forth.

To see how all of this has played out in the actual data for past market darlings, let's take a look at several extraordinary growth companies that can now reasonably be viewed as having reached their "mature" level of market penetration: Microsoft, Cisco, Intel, Oracle, IBM, Dell and Wal-Mart. The chart below presents the combined scatter of historical revenue growth and penetration data for these companies. Again, the key feature is that growth rates are a rapidly decreasing function of market penetration.

Investors should, but rarely do, anticipate the enormous growth deceleration that occurs once tiny companies in emerging industries become behemoths in mature industries. You can't just look backward and extrapolate.

Several years ago, I observed:

"We've seen very rapid adoption rates, very high replacement, and very strong network effects in Apple's products. All of this is an extraordinary achievement that reflects Steve Jobs' genius. I suspect, however, that investors observe the rapid adoption and very high recent replacement rate of three very popular but semi-durable products, and don't recognize how improbable it is to maintain these dynamics indefinitely. Despite great near-term prospects, within a small number of years, Apple will have to maintain an extraordinarily high rate of new adoption if replacement rates wane, simply to avoid becoming a no-growth company. That's not a criticism of Apple, it's just a standard feature of growth companies as their market share expands. It's something that Cisco and Microsoft and every growth juggernaut encounters. Apple is now valued at 4% of U.S. GDP, but then, Cisco and Microsoft were each valued at 6% of GDP at the 2000 bubble peak. Not that things worked out well for investors who paid those valuations."

Presently, Apple is valued at 5.1% of GDP, Amazon at 4.8%, Alphabet (Google) at 4.6%, Facebook at 3.3%, and Netflix at 0.8% of GDP. That's a total market capitalization of nearly 20% of GDP across 5 stocks. It's worth remembering that historically, the pre-bubble norm for market capitalization to GDP, adding up every nonfinancial company in the stock market, was only about 60%. At secular lows like 1974 and 1982, the ratio fell to 30% of GDP – for the entire market.

Despite these extremes, my impression is that the FAANG stocks are not overvalued nearly to the extent that the glamour tech stocks were in 2000, when I expected that group to lose -83% of their value. I expect the Nasdaq 100 to fall by only about -57% this time around. That's actually a big difference, because an -83% loss requires a -57% loss followed by a loss of -60% of what's left.

My expectation for a -57% loss in the Nasdaq is also somewhat less than I expect the S&P 500 (-64%), Russell 2000 (-68%) and Dow Jones Industrial Average (-69%) over the completion of this cycle. Then again, given the severity of our projections, and the likelihood that they'll be far from precise, those are probably distinctions without a difference.

This movie has played so many times in the historical data that we've practically memorized the lines. Near the end of the tech bubble, I got myself a nice bit of scorn on CNBC after Alan Abelson of Barron's Magazine published my projections for Cisco, EMC, Sun Microsystems and Oracle – all in the range of about 15-20% of the prices where they had recently changed hands. Those projections actually turned out to be slightly optimistic.

There's always the hope that this time it's different.

Everyone Hears The Fed... But Few Listen

"See no evil, hear no evil, speak no evil"

Currently, investors appear to be covering their eyes, ears, and mouths and ignoring the Federal Reserve's (Fed) determination to increase interest rates. This divergence of outlooks between investors and the Fed is a stark departure from the financial crisis and the years following when the Fed and the market were on the same page regarding monetary policy.

Often such a discrepancy between the Fed and investors results in sharp changes in asset prices and heightened volatility. In this article, we analyze the current situation to predict whether the market's dovish expectations will be proven right, or if their unwillingness to heed the Fed's warnings will cost them dearly.

Trump vs. Powell

As we were putting the final touches on this article, President Trump sent a clear shot across the bow of the Fed and in particular Chairman Powell.  His message to Powell was simple: stop raising rates. As you read this article consider the position that Powell and the Fed are now in. If Powell walks back his hawkish stance, regardless of why, it will be regarded as acquiescing to the President's request. On the other hand, if he ignores the President and continues to raise rates, we might see his tenure at the Fed limited. Either way the Fed's independence is likely to be tested.

Divergent Views

Starting in 2017, the Fed took a decidedly more hawkish stance than the market was expecting. Whether this was a result of President Trump's pro-growth campaign promises or greater confidence in economic growth and renewed inflationary pressures, we are not certain. We do know that the difference between the market's expectations and the Fed's plans has persisted to this day, despite the Fed raising interest rates five times over the past couple years and reducing their balance in increasingly larger amounts as they've said they would.

The following graphs demonstrate the prior and future divergent views. The first graph compares expectations (using fed funds futures) for the fed funds rate nine months forward versus the prevailing fed funds rate nine months later. The current reading of -0.40% denotes that Fed Funds futures were priced for a Fed Funds rate of 1.60% nine months ago while the fed funds rate is close to 2% currently.

The red dashed line shows investors had slightly higher expectations for the Fed Funds rate than the rate that came to fruition from 2014 through 2016.  Conversely, the green dashed line shows that investors have been too low in their estimates of future Fed Funds rates by approximately 0.25% on average since January 2017.

The next graph looks forward and compares Fed Funds futures to the Fed Funds rate expectations for each member of the FOMC. Each dot represents a Fed members' expectation for the average Fed Funds rate for that particular year. The red triangle denotes the FOMC average for the year. To contrast, the orange boxes represent the average of Fed Funds futures, or the markets expectation for the average fed funds rate, for each year. The differences between market based expectations and FOMC expectations are 0.20%, 0.46%, and 0.63% for 2018, 2019 and 2020 respectively.

A New Curve – A New Narrative

In our recently issued article, The Mendoza Line, we explained that the Fed introduced the validity of using a "New" yield curve versus the customary 2s/10s yield curve at the most recent FOMC meeting. The article points out that an inversion of the customary 2s/10s yield curve has preceded economic recessions with resounding accuracy.

Currently, the 2s/10s yield curve is flattening rapidly and causing the media and investors to take note. The "New" curve has been meandering over the last few years and does not suggest the same caution.

The article's takeaways include the following:

• "The Fed has much more control over the shape of the new curve than the traditional curve."

• "The trend and impending signal from the traditional curve is leading investors to second guess the Fed and their tightening campaign."

• "If, on the other hand, investors buy into the new curve and its upward sloping shape, might they be persuaded a recession is not in sight and their confidence in the Fed will remain strong?"

We believe the Fed is using the "New" curve to try to calm investors' recession concerns and encourage them to raise their expectations for future Fed Funds levels.

The graph below from the article compares the downward slope of the 2s/10s curve to the slightly upward slope of the Fed's New Curve.

Why the Fed is more Hawkish than investors

We believe there is one crucial reason why the Fed is resolute to raise rates more than the market believes. During the last seven recessions, the Fed Funds rate was lowered on average by 7.18%, as shown in the table below. While the last recession of 2008 only saw Fed Funds decline by 5.26%, the Fed introduced a $3.6 trillion bond-buying program known as QE.

If a recession were to start this year or next, with Fed Funds trading between 2% and 3%, the Fed would be significantly limited in their ability to lower interest rates and boost economic activity. The Fed is quite likely providing themselves more room to lower rates in the future, and thus are intent on getting the fed funds rate higher than what the market believes.

The following are other concerns that may also be driving the Fed aggressiveness:

• Surging fiscal deficits – "Fed's Dudley Worries Tax Cuts Risk Overheating U.S. Economy"- Bloomberg

• Tariffs –"The Latest Proposed Tariffs Would Significantly Boost Core Inflation" – Ian Sheppard

• Employment – "Moreover, if the labor market were to tighten much further, there would be a greater risk that inflation could rise substantially above our objective," – Jerome Powell

• Deficit Funding – Foreign holdings of U.S. Treasuries have declined over the last six Higher interest rates may be required to incentivize domestic capital to offset foreign demand.

Investment Implications

In the second part of this series we will discuss how the resolution of the market's dovish opinion versus the Fed's hawkish stance might affect various asset classes.

In the meantime, we share data on how equities and bonds performed during various periods following the last two yield curve inversions.

Summary

As mentioned at the opening, when the market and the Fed have a sharp difference of opinion as is currently the case, the possibility of significant market volatility increases. The Fed is leaving us few doubts that they would like to keep raising rates at a measured pace. Chairman Powell has also voiced more concern than his two predecessors with the prices of financial assets. In fact he has shown unease that some assets are in valuation bubbles.

Chairman Powell brings one distinct advantage to his new role over his three predecessors – he has an odd tendency to speak plain English. That does not eliminate the uncertainties of the economy and a possible change in plans for monetary policy, but it certainly reduces them. Market participants and Fed watchers seem to have been too well-conditioned to the PhD-like jargon of Greenspan, Bernanke, and Yellen and fail to recognize the clear signals the current Chairman is sending.

As stewards of capital who understand the importance of the Fed's interactions, our obligation is to appreciate that this Chairman says what he means and, in all likelihood, means what he says. Rate hikes, although gradual in pace, are likely to keep coming.

Putin: The US Is Making A Big Mistake By Weaponizing The Dollar

After the liquidation of its US Treasury holdings, surging gold reserves, and switching to a non-SWIFT payment system, Russian President Putin attempted to quell general concerns noting that "Russia isn't abandoning the dollar."

In a press conference this morning, the Russian president said his country doesn't plan to abandon holding reserves in U.S. dollars though he said that the risk of sanctions is prompting Russia to diversify its foreign currency assets.

"Russia isn't abandoning the dollar," Putin said in answer to a question about the sharp decline in its holdings of U.S. Treasuries in April and May.

"We need to minimize risks, we see what's happening with sanctions."

"As for our American partners and the restrictions they impose involving the dollar," he added,

"I think that is a major strategic mistake because they're undermining confidence in the dollar as a reserve currency."

Putin did however caution that the US is making a big mistake if it hopes to use the dollar as a political weapon:

"Regarding our American partners placing limitations, including those on dollar transactions, I believe is a big strategic mistake. By doing so, they are undermining the trust in the dollar as a reserve currency"

In this vein, Putin added that many countries are discussing the creation of new reserve currencies, noting that China's yuan is a potential reserve currency, but concluded:

"We will continue to use the US dollar unless the United States prevents us from doing so."

The Russian president also emphasized the need for other currencies in global trade and the emergence of new reserve currencies like the ruble.

Just last night we laid out the four major moves that Russia seems to be taking to de-dollarizeso we suspect this comment by Putin is lipstick on that pig so that the rest of the world doesn't front-run him.

Additionally, President Putin said he's ready to hold a new summit with U.S. counterpart Donald Trump in either Moscow or Washington, praising him for sticking to his election promises to improve ties with Russia.

"One of President Trump's big pluses is that he strives to fulfill the promises he made to voters, to the American people," Putin told a press conference at the BRICS summit in Johannesburg.

"As a rule, after the elections some leaders tend to forget what they promised the people but not Trump."

Putin, who said he expects to meet Trump on the sidelines of the G-20

BOJ Offers To Buy Unlimited Bonds After Bizarre Delay As Yield Surge

While traders' attentions were as usual focused on the latest developments in China last night, around 9pm ET we pointed out that the real action was taking place in Japan, where the 10Y yield had blown out beyond the BOJ's designated range of 0.00%-0.10%...

Yield curve without control pic.twitter.com/EWY17sTa8i

— zerohedge (@zerohedge) July 27, 2018

... and had even crossed into the range above 0.11% where the BOJ traditionally launches its Fixed Rate Operation, also known as Unlimited Buying of JGBs beyond a given rate, something it did most recently on Monday morning (after a 7 month hiatus) when JGB yields also blew out sharply.

Which is why we were wondering when the BOJ would announce the latest "unlimited buying" operation to defend Japanese bonds from a further rout.

What time is the BOJ's Fixed Rate Operation aka "Unlimited buying at 0.11%" op today?

— zerohedge (@zerohedge) July 27, 2018

And it wasn't just us: so were all bond traders and central bank watchers, and yet the hours passed and still nothing from Kuroda.

Then, finally, just around 1am ET or 4 hours after the rout had started, the BOJ couldn't take it any more and announced the long overdue fixed-rate operation for the second time in 5 days after the 10-year yield rose to its highest level in more than a year.

While the BOJ's latest intervention resulted in a lot of relieved traders as the lack of any intervention almost convinced markets that Kuroda was willing to let the long end JGBs "slide", there was a difference: this BOJ offered to buy 10-year debt at 0.10% vs 0.11% at its previous operations. And also unlike Monday's operation, today the central bank actually did end up buying some 94BN yen worth of 10-year bonds.

Commenting on the latest central bank intervention to prevent a bond market crash, BofA's chief Japan rates strategist Shuichi Ohsaki, said that "the BOJ probably wanted to demonstrate its capacity to be flexible by lowering the yield of its fixed-rate operation to 0.1% from 0.11%."

He also noted that this move makes it likely there'll be a tweak at next week's BOJ meeting, and added that the "BOJ wants to send a message that the level for fixed- rate operation isn't set in concrete."

Others chimed in: "The operation is meant to cap the rise in yields and will help to weaken the yen," said Daiwa FX strategist Yuji Kameoka. Still, "the yen is unlikely to fall much, given policy doesn't change until the BOJ's meeting next week."

"By offering to buy an unlimited amount of bonds at 0.10% in Friday's fixed-rate operation, the BOJ is showing resolve to contain the rise in the 10-year yield, while also signaling its willingness to be flexible", said Takenobu Nakashima, quantitative strategist at Nomura Securities in Tokyo.

If it had offered at 0.11% today, it wouldn't have sent the message about flexibility; if the fixed rate was set as 0.12%, it would have given the impression the BOJ will let yields rise.

Whatever the BOJ's motive for a) being so very late to intervene and b) changing the parameters of the fixed-rate operation, the real question is what this means for next week's BOJ announcement. And if the sharp spike in JGB vol is any indication, then Kuroda may be preparing to finally let the market take control over the world's most zombie instrument: Japan's bond market. If that is indeed the case, watch out, as true price discovery in this "market" hasn't happened in several years, and if Kuroda is not careful, the Kyle Bass short JGB "widow-maker" trade may soon be better known as "billionaire-maker"...