Bonds are in news & there have only been conjectures to what is going on. These are uncertain times for investors but exciting times for economy watchers.
By Ritesh Jain
Hey there!
Do you notice this? Given the statistical correlations, it is almost impossible that equities, bonds, precious metals and the dollar can rally together. But they are doing, aren’t they? And it has been a breathtaking one since the Brexit vote. So, what’s wrong here?
Bonds are making big news these days and there have only been conjectures as to what is really going on. In a career spanning more than three decades, Jeffrey Gundlach had never seen the conditions the bond market faced last week. His report was teeming with insights.
These are uncertain times for investors but exciting times for economy watchers. Real economics shapes up in times like this! Read on...
1. Funds bet that emergency global stimulus will trump Brexit worries Ambrose Pritchard writes about what has led to this rally in this piece published in Telegraph.
Elite funds and banks are amassing global equities and emerging market assets, betting that precautionary stimulus around the world will overwhelm any damage due to Brexit and drive one last leg of this ageing financial cycle. It is a risky strategy at a time when the world economy is so precariously balanced with almost $12 trillion of debt trading at negative yields.
The hypothesis is that the authorities have overreacted from fear of contagion from Brexit and changed their policy stance.The US Fed has stepped back from the long-feared monetary tightening with futures not pricing in any rate hike till December 2017. Japan has also drawn up plans for a stimulus package of $100bn to counter the effects of the surging yen, even talking of handing out shopping coupons, the ultimate “helicopter money”.
Brexit has certainly been a psychological shock but the knock-on effects for the global economy are hard to calculate. While the vote could have violently “non-linear” effects if it exposes deep internal rifts within the EU or start a European banking crisis, little has happened so far. Key stress gauges such as the dollar Libor-OIS spread and the Ted Spread have barely moved. Meanwhile, the euro zone is in full retreat from fiscal austerity, alarmed as populist revolt nears critical thresholds in a string of countries.
Flattening yield curve in the global bond markets would normally be a forward indicator of recession, and it would be courting fate to assume that this time is different.Click here to read more.
2. The surprise of a career time for Jeff Gundlach In a career spanning more than three decades, Jeffrey Gundlach had never seen the conditions the bond market faced last week. Indeed, he said the “setup for the 10-year treasury was the worst in his career.” Gundlach spoke to investors on July 12 to provide updates on two mutual funds, the Double Line Core Fixed Income Fund (DBLFX) and the Double Line Flexible Income Fund (DFLEX).
Two elements created the ominous market conditions, according to Gundlach. Yields had moved to new lows, and investor sentiment became exceedingly bullish on bond prices. His concerns were justified. Since July 5, the yield on the 10-year Treasury has risen 16 basis points from 1.37 per cent to 1.53 per cent. The previous low yield for the 10-year treasury was 1.39 per cent in July 2012.
The bullish sentiment in the bond market, Gundlach said, was from pundits who were calling for a 1 per cent yield on the 10-year Treasury. But the return from that move would be too small to compensate for the risk of an adverse move in yields.
The misguided bond-market sentiment can be found in statements like, “Bond yields simply cannot go up,” and, “Nothing can make them go up.” Gundlach said that sentiment is similar to early this year, when gold was at $1,075 and may claimed it could not go up. But gold went up 30% to its current price of nearly $1,400.
3.Chart of the quarter & a possible recession
One of the reasons the setup for bonds was so negative, Gundlach says, is because of troubles in the banking system. Below is what Gundlach called the “chart of the quarter”:
It compares the price movement of Bank of America’s stock from 2005-2009 to that of Deutsche Bank since 2013. In both the cases, there was a slight appreciation followed by a “total collapse,” he said. Deutsche Bank’s stock closed at $14.10 on the day Gundlach spoke. He predicted that when its price goes to single digits you will see calls for bailouts, and pointed out that this is already happening in Italy and Germany.
The next response to those bank problems will be “bond unfriendly” – deflationary – and will take everyone by surprise, he said. Those responses could include bailouts, “helicopter money” or a large fiscal stimulus, according to Gundlach.
Ironically, Gundlach said that the UK – the country that is leaving the EU – has actually been the strongest of the big European equity markets. That is based on the FTSE 100, which is an index of large firms. Those companies have been aided by the collapse of the pound, Gundlach said, and that currency weakness has started to reverse.
As a result of the “Brexit” vote, Gundlach said the probability of a Fed hike is down to zero for 2016, including the July, September and December meetings. There is a probability of one-third of a rate hike for the February 2017 meeting.
The Fed has “completely capitulated” in its plan to raise rates, Gundlach said. Market indicators are signaling neither inflation nor a recession. Gundlach said the CPI is moving “sideways” at about 1% and the real-time “Price Stat” indicator has been flat.
Gundlach’s overall theme on the bond market was decidedly negative. He said this is not a good time to enter the bond market, particularly long-dated bonds. Be cautious about duration in the bond market,” he said. “I would not be surprised if the 10-year went to 1.7%,” he said. “That is the base case we are looking at.” But he added that investors should not bet on very high rates, which won’t be an issue until a few years from now.
4. Where is the US economy headed?
Real per capita GDP of US has risen by a paltry 1.3 per cent annualised since the current expansion began in 2009. This is less than half of the 2.7 per cent average expansion since the records began in 1790. Six considerations indicate federal finance will produce slower growth:-
► Government expenditure multiplier is negative ► Composition of spending suggests the multiplier is likely to trend even more negative; ► Federal debt-to-GDP ratio moved above the deleterious 90% level in 2010 and has stayed above it for more than five years, a time span in which research shows the constriction of economic growth to be particularly severe ► Debt is likely to restrain economic growth in an increasingly nonlinear fashion ► First four problems produce negative feedback loops from federal finance to the economy through the allocation of saving, real investment, productivity growth, and eventually to demographics ► Policy makers force the economy into a downward spiral when they rely on more debt in order to address poor economic performance. More of the same does not produce better results. It produces worse results, a situation we term a policy trap.
When deficits and debt impair growth, saving is increasingly misallocated, shifting income that generates public and private investment into investments that are either unproductive or counterproductive. Then the deterioration in real investment, productivity and demographics reverberate to the broader economy through negative feedback loops that suggest that as debt moves ever higher, the restraining effect on economic growth turns nonlinear.
The government expenditure multiplier is negative. Based on academic research, the best evidence suggests the multiplier is -0.01. Although only minimally negative at present, the multiplier is likely to become more negative over time since mandatory components of the government spending will control an ever-increasing share of budget outlays. These outlays have larger negative multipliers.
In 2015, the composition of federal outlays was 68.3% mandatory and 31.7% discretionary; the composition was almost the exact opposite in 1962. Mandatory spending includes Social Security, Medicare, veteran’s benefits and the Affordable Care Act. All of these programs are politically popular and conceptually may be highly laudatory.
Due to the ageing of America, the mandatory components of federal spending will accelerate sharply over the next decade, causing government outlays as a percent of economic activity to move higher. This suggests that if spending increases, the government expenditure multiplier will become more negative over time, serving to confound even more dramatically the policy establishment and the public at large, both of whom appear ready to support increased, but unfunded, federal outlays.
With slowing nominal economic growth, Treasury bond yields are likely to continue working lower. Stressed conditions in major overseas economies have pushed 10- and 30-year government bond yields much lower. In fact, the 10-year yield has turned negative in both Japan and Germany. Foreign investors will continue to be attracted to long-term US treasury bond yields. The slowdown ahead will cut the already weak nominal growth trajectory. Consequently, with the normal lag, the annual inflation rate, should begin to turn down as the year moves to a close.
From California to China, the banking industry is increasingly being challenged by digital disruption. FinTech is changing the world of finance! This is what exactly Credit Suisse (CS) report on ‘Digital banking in India’ talks about dramatic transformation of the country’s financial landscape with the advent of instantaneous, cashless, paperless, presence less financial transactions.
India, by size (1.2 billion and counting), low banking penetration, policy initiatives (J.A.M.) and the ubiquity of mobile phones (c80% penetration) is a big FinTech opportunity. It’s disruptive, is creating opportunities and will change Indian banking. The banks have clients and scale but the new FinTech entrants usually have the innovation edge. To remain competitive, banks need to get innovation before the FinTech companies get scale. We see markets expanding materially and banks could gain disproportionately if ready. It’s going to be survival of ‘the quickest’!
CS report tries to crystal-gaze on how the Indian financial landscape is likely to transform. The report identifies holy trinity of J.A.M. (Jan Dhan, Aadhar and Mobile) and advent of Unified Payment Interface (UPI) which has created backbone for instantaneous, inter-operable, cashless financial transactions. As India goes from being data poor to data rich in the next 2-3 years, data becomes the new currency and financial institutions will be willing to forego transaction fees to get rich digital information on their customers. It also means customer ownership will rest with best interface providers and incumbency of deposits will be challenged. Business models will be redefined and several revenue streams could be at risk. CS estimates the consumer and SME loan market will grow from $600 billion to $3,020 billion in the next ten years.
Changing ecosystem – J.A.M. initiatives: These three systems, which are getting integrated with each other, are expected to allow a range of innovative services to be implemented in a paperless, instantaneous and cost-effective manner. ► Jan Dhan (Financial inclusion). In 2015, the number of unbanked population almost halved from 2014 level to 233m. ► Aadhar (National Identity card): This now covers over 1bn people, provides online identification and KYC. ► Mobile: Mobile phones penetration ~80%, ~100mn smart phones sold per year (+40% YoY), and rising broad-band connectivity (100% targeted by 2018).
Unified payment interface to shift to cashless: Unified Payment Interface (UPI), developed by National Payments Corporation of India (NPCI), allows payments to be initiated by the payer, or by the payee. UPI is linked to accounts where everyone with a bank account in India can participate, and send money to any bank account in India. It facilitates real-time posting to both the payer’s and payee’s accounts without funds getting locked. UPI allows bank account portability and end users need not disclose bank account information. It is also cost effective with no more card/PIN issuance/POS cost while customer smart phone acts as card and POS.
J.A.M and UPI will impact critical aspects of the banking business: While India may follow other developed markets in terms of impact from digital payments, there are many outcomes which could be unique to India. a)Cost of transactions could head to zero b) The best customer interfaces (read apps) could own the customer c) Incumbency of deposit accounts can be challenged.
Digitization will accelerate the process of disintermediation and new business models will emerge: The process of disintermediation of retail deposits as seen over the past few decades is going to accelerate significantly with digitization. Further several revenue streams especially those one which needs least customer engagement, could be at risk of disruption due to digital revolution. Hence franchise of savings accounts could be challenged or margins on remittances / mutual fund sales commission could witness steep decline in coming years for the banking sector.
Retail loans to increase 5x over the next 10 years: Banks have primarily focused on mortgage linked loans to drive retail loan growth with the share of unsecured loans quite low. The retail lending mix is set to change significantly as data availability will allow banks to offer transactional products rather than asset backed products. Based on a bottom-up analysis of the key retail segments (housing, auto, personal, small business loans, etc.), CS estimates that total retail loans are set to increase 5x over the next ten years. It estimates consumer loans-to-GDP to increase to 25% of GDP by FY26 (from 17% as of now) driven by the increase in mortgage penetration (~13% by FY26) and contribution from personal and other unsecured loans. SME loans are expected to register a loan CAGR of 17% resulting in SME loans-to-GDP increasing to 10% by FY26 from 7% now.
GST could be a gamechanger for SME lending: Under the proposed GST structure, tax payers will file returns through a common interface developed under the GST Network. Actual tax will be paid in the bank and only challan details will be uploaded on the GSTN. The common portal, in addition to reconciling returns and challans, will also become a repository of all commercial B2B transaction records in the country in a single digital format. It is estimated that 3-5bn invoices will go digital with GSTN annually. This could be a rich source of information on SMEs, who have so far been operating in informal sectors with little documented transaction data.
Difficult to pick winners: As most banks are in the early stages of their digital transformation, it is difficult to pick winners. Success in migrating and adapting customers to their platforms will be the key to value creation. Banks (and non-banks) that "own the customers" will be the key beneficiaries of digitization as access to information will help them to deliver products cost-effectively. Benefits of digitization could improve consumer banks' profitability by 30-70% through a combination of lower costs (cost to asset lower by 30-60bps) as well as better revenues from acceleration in customer acquisition, higher cross-sell ratios, and a rise in fee income (5-8% higher growth in fees and loan book).
So, when RBI Governor Raghuram Rajan said, “A banking revolution is upon us”, he actually meant it!!
(Ritesh Jain is the CIO of Tata Asset Management. Views expressed in this weekly column are personal in nature and do not represent those of Tata AMC or ETMarkets.com. It should not be construed as an investment advice. Any action taken by the reader or recipient on the basis of the information contained herein is reader's/recipient's responsibility alone.)
