Negative interest rates mystify Howard Marks, along with the rest of us. In this summary, he considers why they are arising and what the impact will be. He makes some connections you probably won’t see elsewhere.

Key Points:

  • Until the Global Financial Crisis, governments and banks paid investors to store their money. Rising fear is reversing that practice.
  • Over $17 trillion in government and corporate debt now trades at negative yields. Adjusted for inflation, it is more than $35 trillion, including more than $9 trillion in US Treasury debt yielding less than CPI (Consumer Price Index) inflation.
  • Negative yields make sense if investors expect deflation instead of inflation, but other explanations are also possible.
  • Whatever the reasons, negative rates turn some longstanding principles on their heads.
  • For one, Einstein’s observation on the “miracle” of compound interest is actually a curse if interest rates are negative. Risky investments become preferable while risk aversion is discouraged.
  • Businesses no longer have reason to pay slowly in order to maximize their “float,” nor is there any impetus to collect receivables quickly.
  • The pessimistic signals sent by negative rates may have a contractionary, not stimulative effect. We already see this in lower inflation expectations and higher savings rates in Japan/Europe.
  • Negative rates warp the calculation of discounted present values. The present value of future pension obligations can exceed the future value, which is highly problematic for pension funds.
  • Perversely, under negative rates, a highly-leveraged borrower might actually be more creditworthy than a cash-rich one.
  • Marks doesn’t think current conditions will bring negative rates to the US but also doesn’t rule it out.

Bottom Line: Marks says the solution to a negative rate investing environment is to buy things with durable cash flows. The challenge is finding them at reasonable prices. We are having to rebuild all our assumptions, so accurate predictions are even harder than ever.


Three Critical Factors For China’s Future Growth

China’s GDP (Gross Domestic Product) growth dropped to a new 6.0% low last quarter, if we can believe the official stats, and the slowdown seems likely to continue. Yet, there are also signs of stabilization. Gavekal’s Andrew Batson reviews three possible sources of good news and what they could mean for China and the world economy.

Key Points:

  • China’s total exports are down slightly this year in USD terms and actually up in renminbi. But, the damage from US tariffs is cumulative and getting worse.
  • A trade deal with the US probably won’t help China much unless it eliminates existing tariffs and stops new ones. Batson expects little improvement in the trade numbers until mid-2020.
  • Beijing is reversing its hawkish policy that created a summer liquidity squeeze. Loan growth is picking up, which looks positive for domestic investment.
  • However, with export growth weakening, private firms have little incentive to expand capacity. So, easier credit access may not boost growth much.
  • Declining car sales since 2018 had little to do with consumer spending and was more related to tax policy changes and new emission standards.
  • Auto sales growth should stabilize as these factors work through the system. This would remove a big drag on economic activity.

Bottom Line: Chinese economic indicators should stop getting worse in the next few months, but there is little reason to expect a significant growth spurt. Much like the US and Europe, aggressive stimulus appears to be reaching its limits.

The most liquid China large-cap ETF (FXI) has been testing (down trendline) resistance again.


FXI Shares China Large-Cap ETF


Six Things We Are Watching In The World Markets

First, worldwide economic growth is weakening, with some key markets approaching recession. This week, the International Monetary Fund (IMF) reduced its 2019 global growth forecast to 3.0%, the lowest since 2009 when recession was still underway. They think it will improve to 3.4% in 2020. That’s better than the alternative but not much of a recovery.

Note, that’s the global average, which would be lower without considerably above-average growth in China and India. IMF pegs US growth at closer to 2%, with Japan and most of Europe even lower. Problems in China could worsen the IMF’s outlook quickly.

Second, if you don’t want to believe the IMF (and there’s reason to be skeptical), look at global shipping trends. The economy is increasingly digitized, but the movement of physical goods is still its circulatory system. The latest Cass Freight Index data shows global blood pressure is dropping, when looking at the trends on both the total shipment and expenditures basis. Shipping volume has been down for 10 straight months on a year-over-year basis.

Third, monetary and fiscal stimulus is proving less effective. Not that it was so great last time, but it helped. It also had side effects that may have reduced its usefulness. You can’t force credit on those who don’t want or need it, even at zero or negative rates. The European Central Bank and Bank of Japan are learning this the hard way.

On the fiscal side, the 2017 US corporate tax cut helped, but the trade war offset some of it. Other countries, because they don’t have the dollar’s “exorbitant privilege,” have less fiscal flexibility than the US. Hence we see, for instance, Mario Draghi practically pleading with European governments for more stimulus spending and those governments shrugging their collective shoulders. They can’t do it.

Fourth, the US budget deficit is huge and growing. As I’ve shown, a recession in the next few years will likely push it far higher as revenue drops and spending rises. The Treasury’s increased borrowing is also having an effect on credit markets.

The investors who aren’t plunging into stocks seem to be holding more cash. Money market balances have been creeping up. A little caution might seem to be in order, but it matters where investors store their cash. If it’s not available for the banking system to grease its wheels, bad things can start happening. (More on that in a minute.)

Fifth, we are starting to see confidence break in important corners of the capital markets. The WeWork IPO (Initial Public Offering) turned into a fiasco. In fact, the entire company looks just like the train wreck Grant Williams said it would be. I don’t see how anybody could look at the business model of WeWork and not see an obvious hustle. What does that say about the supposedly brilliant venture capitalists who threw cash at the company? Nothing good. Though, maybe they knew what it was and just figured they could flip their shares to the public before it fell apart. If so, they appear to have been wrong.

But, the broader point is that once-invincible Silicon Valley unicorn companies are losing their allure. It turns out business success is hard when you have to actually, you know, generate more revenue than expenses. Other WeWork-like stories are probably coming. Nor is it just unicorns; look at Boeing’s struggle to fix the 737 Max planes and the shortcuts we are learning it took. These are bad signs for a market that needs earnings growth if it is to maintain current prices, much less see them rise further.

Sixth, as I was wrapping up this email, the latest Ambrose Evans-Pritchard column hit my inbox. He read the IMF’s latest financial stability report and came away with a distinctly darker view:

The International Monetary Fund has presented us with a Gothic horror show. The world’s financial system is more stretched, unstable, and dangerous than it was on the eve of the Lehman crisis.

Quantitative easing, zero interest rates, and financial repression across the board, have pushed investors—and in the case of pension funds or life insurers, actually forced them—into taking on ever more risk. We have created a monster.

There are ‘amplification’ feedback loops and chain-reactions all over the place. Banks may be safer—though not in Europe or China—but excesses have migrated to a new nexus of shadow-lenders. Woe betide us if this tangle of hidden leverage is soon put to the test.

According to the IMF, globally there is about $19 billion of “debt-at-risk,” in which a global slowdown and/or recession would render borrowers unable to make their payments. I have written a great deal about the high-yield and leveraged loan market in the US, but globally it is much worse.

“In France and Spain, debt-at-risk is approaching the levels seen during previous crises; while in China, the United Kingdom, and the United States, it exceeds these levels. This is worrisome given that the shock is calibrated to be only about half what it was during the global financial crisis,” it said.

…In Europe, almost all leveraged loans are now being issued without covenant protection. The debt to earnings (EBITDA) ratio has vaulted to a record 5.8. Is the ECB (European Central Bank) asleep or actively promoting this?

The IMF’s directors call for “urgent” action to stop these excesses, but in the same breath, suggest/admit that the cause of leverage fever is the easy money regime of the authorities themselves. That is to say, the central banks and their political masters who refuse, understandably, to permit debt liquidation and to allow Schumpeter’s creative destruction to run its course in downturns.

Don’t think it can’t happen. There will be canaries in the coal mine that will chirp before the dominos start falling, and we will sound the alarm LOUD and CLEAR.


Where Are We In This Market Cycle

Howard Marks, CFA, is Co-Chairman of Oaktree Capital—the firm he founded in 1995—and one of the most successful hedge fund managers in the business. He comments on the market cycle here:

The current economic cycle is more than 10 years old—the longest on record. By almost all measures, equity market valuations are near record highs. The length of the cyclical bull market is now the longest in history. And, most significant, we sit at the end of a long-term debt accumulation cycle. Moments like this one are problematic. That’s the bottom line.

Here we are based on market valuation in a long market cycle. The higher the valuation, the lower projected future returns:



Stock Market Seasonality

The best six months to be in the markets are from November 1 to May 1, and the worst times to be invested in the markets are from May 1 to November 1 of each year. November is coming quickly. See chart below:



The chart below shows the gain of $10,000 invested since 1957 in the S&P 500 index during the seasonally strong period (November through April) as opposed to the seasonally weak period (May through October).



The Good News Of The Current Market Advance
  • The ECB announced more QE (Quantitative Easing)
  • The Fed reduced capital requirements and initiated QE
  • The Fed is cutting rates
  • Trump, as expected, caved into China
  • Stock buybacks
  • New home sales look fine
  • Morgan Stanley’s US recession probability model has turned lower in recent weeks
  • Economists expect Mexico’s economy to strengthen next year.
  • The percentage of companies beating Q3 earnings estimates by more than one standard deviation was one of the highest on record (Stock Buybacks)


If You Are A Bull, What’s Not To Love?
  1. The trend remains bullishly biased, and;
  2. We are now entering into the historically stronger period of the investment year. Seasonality turns positive November 1st.


S&P Trading Volume

The S&P 500 trading volume has been declining, which could create a liquidity problem during the next selloff.



Market Data
  • Another one bites the dust. The Conference Board’s Leading Economic Index (LEI) is a popular indicator to watch for potential recessions ahead, and the latest reading shows a second consecutive drop month-over-month.
  • Temporary plateau. The LEI hasn’t gone much of anywhere for a year, showing signs of a long-term plateau.
  • Never better. A weekly Bloomberg survey shows consumers have never been so confident that right now is a good time to buy. Going back nearly 35 years, the survey’s Buying Climate portion has exceeded its prior high from January 2000.
  • Stocks have been rising on lower volume. As a percentage of market cap, volume is the lowest in a year.
  • The S&P 500 hasn’t gone much of anywhere over the past six months, but it has swung back and forth quite a bit.
  • A concerted flight to safety. Looking at a handful of different flight-to-safety trades, it’s evident that there has been a lot of risk-off positioning in recent months. Ratios of defensive to cyclical stocks, gold to copper, among others, have had an extremely high positive correlation over the past three months.

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