The interest rate cycle (February 2018)

February 2018

It was a bad month for markets although, as we have written in previous reports, a reversal in markets had become quite overdue. UK shares fell by 3.4%, European shares by 4.7%, US shares fell 3.9% and Japan fell by 4.5%. There was little support from any other asset class. Gold was down 2.0%, oil 4.7% and US bonds 0.9%. Only European and UK bonds were flat. Falls in all of the above were steeper intra-month than the full month figures suggest; some countertrend buying came in late on.

It is of course possible that February’s correction is just another downward blip in an otherwise unbroken up trend. But it is also possible that the peak in equity markets has been reached for the current long term cycle (see main section). Ever since the bank rescues of 2008, markets have risen, in the case of the US by a large amount. But based on good old fundamentals, we have protested that there is an artificiality about the last 8 years which should eventually unravel.

Many investors have felt this way too although a fair number of them have capitulated and jumped in to markets regardless – often through passive auto pilot vehicles. We remember the former head of Citigroup Chuck Prince. He is now best known for saying “As long as the music is playing, you’ve got to get up and dance” He said this in 2007. In 2008 Citigroup needed an emergency rescue from the US taxpayer.

For at least 2 years and in some cases longer, we have seen the inherent level of risk in markets rise by a number of measures and we have drawn attention to them in these monthly reports. Foremost among these has been the interest rate cycle which seems to have turned decisively, particularly in the US. Other countries normally follow America.

Among other risk warnings were:

  • volatility (the “fear gauge”) was at an all-time low ie investor complacency was extremely high. Something was bound to spook investors at some point as fear returned.
  • low cash levels for most investors. Most pension funds and mutual funds are pretty fully invested. This would likely exacerbate any fall because there would not be much money arriving to “buy on the dip”.
  • high valuations and debt levels (govt, companies and individuals) . People have bought shares on margin.
  • passive investing and ETFs ie autopilot investing has come to dominate investment. These vehicles lend themselves more readily to panic selling by investors than active funds – easy in, easy out.

Being right about all or any of the above factors (assuming even that we were) doesn’t count for much in an investment sense because to make money you need other investors to come to see the world as you do. You need patience because the herd can move in the opposite direction for a long while. You also need to have faith that fundamental laws will reassert themselves eventually even if market participants would prefer them not to.
 


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The interest rate cycle

US interest rates have been rising for a while. Both the Federal Funds rate (short rate) and the 10year bond yield bottomed in the middle of 2016 and went up throughout 2017. In the June HLI Core Fund monthly report we wrote:

“It is possible that we will look back on this most recent interest rate rise in the US as a turning point because of the change of narrative which accompanied it.”
 
US Federal Funds Rate (Short rate) now at 1.5%


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We also pointed out that the bond market often precedes the equity market by between 6 and 12 months. This is looking right.

The falls in February were attributed by the papers to interest rates. (It’s nice when the papers catch up because that’s when it becomes common knowledge).

At the end of January, the US Federal Reserve appointed its new leader, Jerome Powell. He said that the Fed would need to raise interest rates a little bit faster than his predecessor Janet Yellen had indicated. Markets were spooked, but in fact there was nothing in Powell’s comments which wasn’t visible to investors a year ago. Patience is a virtue but markets can defy you while you wait, as they did this time too hitting highs in January 2018.
 
10 year yield more than doubled from its low of 1.35% in 2016 to current level 2.83%


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Time Lag
US Shares- The SPX continued to rise hitting a new high in early 2018, a year after the 10 year rates started rising


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Long Cycles

“There will be no more boom and bust” Gordon Brown, Dec 1999

The elitist meddlers in the global economy – broadly the people who congregate in Davos each January – like to believe that they have conquered the business cycle. Unlike King Cnut they continue to push this line.

However, the recurring theme of these reports is that the long term business cycle does ultimately prevail and that attempts to control or smooth it end up accentuating it. Furthermore, such attempts have unintended consequences which can take a long time to emerge.

Interest rates not only act as leading indicators for the course of the stock market but also for the economy as a whole. Here is a picture of the business cycle in action since 1950. The chart shows the level of US prime lending interest rates (which price off the Federal Funds/US Base Rate) and years of recession in the vertical blue bars. Almost always a recession follows a period of rising interest rates.
 


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The chart above not only shows the connection with recessions but it also shows that there is a very major cycle at play over and above the shorter cycles. The world looked quite different in the 25 years before 1982 than it did in the 36 years since. Things started to get out of hand when the US money system broke its last connection with gold in 1971, which led to a surge in inflation which was quashed by somewhat extreme interest rate hikes by Paul Volcker in 1981. Monetary policy has been a series of major swings back and forth to try to win control of an ever more difficult beast while also managing the unintended consequences of the policy eg 1987 crash, 2001 crash, 2008 crash.

In 1982 the world looked like this compared with today:
 


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There are few people around who sincerely believe it could return there ie that the data on the above table return to their 1982 levels. However, without wishing to sound sensationalistic and while fully acknowledging the hazards of making any guesses at all about the future, a case can be made for believing that we are at or near a 30 year turning point for the giant cycle which would mean that the data would point once again towards the 1982 levels albeit from a long way away. We have had an amazing 35 year bull market in shares and bonds (falling interest rates), which at some stage will have run its course. The key thing to watch is the US 10 year interest rate and in particular whether it has broken out of its 30 year downward trend channel. Some people think it has.
 


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What would this mean for shares?

Clearly, shares would give back a sizeable proportion of their gains since 2008.
 
US Shares since 1997


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It should be noted that the US has performed as a bit of an outlier. Despite similarly accommodative interest rate policies in other countries, their respective stock markets have not performed as well. A key question would be whether they would be any more resilient on the way down, were the US to suffer falls. In the past, they have not been ie when the US falls, they fall too.
 
UK Shares since 1997


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Japanese Shares since 1997


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European Shares since 1997


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Why does the Business Cycle Ultimately always prevail?

Because the business cycle is fed by debt and eventually the debt becomes due for repayment.

To recap how the business cycle plays out

The meddlers in Governments, through their agents, the Central Banks, and initially supported by their electorates create the illusion of prosperity by encouraging the widespread take-up of debt among companies, individuals and their own spending departments. This is the main policy “tool” in their workshops. It manifests itself through inflating the money system and by setting interest rates too low ie lower than their natural rate as determined by the free market supply and demand of savings.

Initially the policy works as desired. It is easy to stimulate the economy in the early days. Consumption rises, growth is positive, asset prices go up. But later on when the debt is repaid (or written off by the lender) these factors reverse. So underlying the policy is the desire/necessity never to see the debt either repaid or written off.

Some people describe the repayment phase as deflation which they say is to be avoided. Actually, this is debt deflation – the hangover caused from repaying borrowing. Real deflation is a positive consequence of increases in labour productivity which makes people richer ie there are more flat-screens, telephones, food, toothpaste, soap, and holidays for your money.

The process of borrowing to stimulate is highly distorting. After the repayment or bankruptcy phase has finished, the status quo is not as it was before the boom started. Some people win a lot but most lose and end up in a worse place than they would have if the boom had not occurred. The encouragement of borrowing causes people to make mistakes which they have to live with, often for their entire lives.

If only one country enacted this policy the effects would be quickly recognisable through its currency exchange rate – the currency would weaken. But if many countries do it together then the effects can be obfuscated. Countries pretend that they are having currency and trading wars with each other. But in reality the wars just shield them from a far more destructive credit creation policy in their own domestic economies. Even the traditionally financially prudent Germany is forecast to go massively into debt within 5 years.

 
Forecast German Budget Deficit EUR Bn


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Why the recap?

The recap is a reminder that the cycle exists because of debt. It feeds into the real economy most clearly through interest rates which encourage borrowing when they fall and punish it when they rise. It leads to booms and recessions.

There are two rules which have become recurring (broken record) themes of these reports:

  • What the Central Banks giveth, they also taketh away
  • You cannot create genuine prosperity by printing money – all you can do is transfer it from one group of people to another.

Summary

Equity bull markets don’t give up without a fight. There could be more life left in them yet. But if we have seen a break in the 35 year downward trend of US 10yr interest rates, then they will find it hard to continue upwards from here.
 
 

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