The Market Radar

We anticipate, monitor, and comment on market moving global economic and geopolitical issues.  No dark side brooding, no wanting the world to end, no political rants.  Traders, investors, policymakers, or market observers can’t  afford to ignore us.

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The Chart That Floats Overvaluation

We hear a lot these days about how all assets are overvalued.  Very and don’t disagree.

Lots of gurus and big money managers engaging in market crash talking.   Doubt it, but could be wrong.  Too much liquidity and cash in the system.

The repressed -lower than non-market – risk-free interest rates provide the theoretical foundatiom for overvaluation as cash flows are discounted at an artificially low discount rate.   However,  though over/undervaluation is a theoretical/subjective/historical concept, price is the reality that determines valuation and is driven by good old fashion buying and selling.   Capital flows, my friends.

I remember the days when i-banking analysts would come and see me at the hedge fund where I worked in the mid-1990’s talking about where credit spreads should be valued and trading.  I always retorted, “let me know when you see the buyers show up that will drive the spreads to those valuations.”

The buyer finally showed and its name was  Long Term Capital Management.   The problem was they bought with tremendous amounts of leverage and there were no buyers and liquidity when they needed to sell.  And, in hindsight, they were just about the only buyers which drove spreads to where they deemed were correct valuations.   In other words,  they were the market.

Just before the 2008 financial crisis,  the justification for overvaluation of almost all asset classes, including housing was “excess global liquidity”.  “Can’t fight the wall of money.”   “Money, money, everywhere.”    I wrote a piece in December 2006,  The Global Flood (of Liquidity),

There’s little doubt financial historians will find the first half of the first decade of the new millennium fascinating.  The hindsight of history will allow for better analysis of the factors which drove the general and significant repricing of risk in both financial and real assets.  Much of the focus will be on improved  fundamentals, such as the low inflationary growth “Goldilocks” economy, the rise of China and India, productivity gains and corporate profit growth,  and gains from globalization.

The great debate, however, will be over the timing of the move and simultaneous price breakouts in asset and commodity markets.   The sharp rise in home prices, collapse of credit spreads, flattening of yield curves, rise in commodity prices, strength of foreign currencies against the dollar, rally in global equity markets, and decline in implied volatility all began in late 2002 – early 2003.   Can the longer term fundamentals explain what appears to be the “commoditization” of asset markets, which seemed to take place over night?

There are no mystical forces that drive market prices, which ultimately move on supply and demand.  Unlike a relative price move, a general repricing of assets is usually the result of a significant shift in liquidity conditions and monetary factors, which increases global demand for everything from goods and services to financial and real assets.  As the economy “dishoards” excess liquidity, prices tend to rise across the board.  – The Global Flood (of Liquitidy),  Dec 2006

I asked a prominent economics professor to review and comment on that piece.  He said I needed to distinguish the difference between iquidity created by central banks and credit in the system.    Credit was leverage.  How prescient.

It was the global credit bubble that drove all assets markets in mid-2000’s which ended up in,  well,  you know.

Today we have pockets of credit bubbles,  in auto lending, student loans,  the fracking sector,  for example, but it just doesn’t feel, in our opinion,  systemic as it did in 2007-08

No doubt debt has increased, much of it developed market sovereign which has been monetized by quantitative easing,  resulting in repressed interest rates and a structural shortage of tradeable risk-free bonds.

The data show the Fed owns about 35 percent of Treasury securities with maturities 10-years or longer. Note the data only include notes and bonds and excludes T-Bills.

The Fed’s holdings combined with foreign ownership of longer maturities — more than 1-year — exceeds 80 percent of marketable Treasuries outstanding.   The Fed combined with just foreign official holdings, mainly, foreign central banks,  is 65 percent of maturities longer than 1-year.  Thus, almost 2/3rds of tradeable Treasuries longer than 1-year are held by entities with no sensitivity to market forces.  – The Broken Bond Market, GMM, March 2017

But take a look at the data.   The chart below from the Fed’s Flow of Funds data show that total annual borrowing of the domestic nonfinancial sector excluding the Federal government is only back to the levels where it was in 2003.   Furthermore,  total borrowing excluding the Federal government in 2016 was only 57 percent of the peak borrowing in 2007.

Domestic Borrowing_FoF


Note also the net borrowing excluding the Federal government was net negative during the height of the crisis.   No credit growth, no economic growth.

…credit is the mother’s milk of growth; without credit the economy cannot flourish.Mark Zandi

Nevertheless,   the data seems to indicate, at least to us, the economy is not as leveraged as it was in 2007,  though big banks are bigger and the Federal government has almost doubled the size of its debt,  but most of which,  65 percent of longer-term securities,  are held by the Fed and foreign central banks.

Paradoxically,  the Federal government has almost doubled its debt over the past 10 years and the markets suffer from a shortage of Treasury securities.

Global Monetary Base
That brings us to the chart that floats all valuation boats.

We have estimated a global liquidity concept called the “global monetary base” which is simply the sum of the U.S. monetary base and the world’s official foreign exchange reserves.   Since most of the official FX reserves — about 65 percent — are held in dollars most of the global monetary base is in the U.S. financial system.

Global Monetary Base

Note that in 2007 the global base was at about 50 percent of U.S. GDP compared to almost 80 percent at the end of 2016.

The U.S. financial system is flush with liquidity as measured by the global monetary base and has declined only slightly over the past few years, mainly due to China’s reduction in foreign exchange reserves (which has ended up in NY and California real estate) and some valuation effects of the dollar.

This liquidity, in our opinion,  coupled with artificially low rates keeps the overvaluation of assets afloat.   Remember,  it wasn’t until the deleveraging process began in 2007-08 did overvalued assets crack.  Markets need a catalyst to regress back to long-term or overshoot their equilibrium valuations.

Our sense the overvaluation will work off through time unless inflation really begins to pick up and the Fed has to accelerate the pace of balance sheet reduction.   Or it could be some type of geopolitical shock, where assets immediately reprice with very little trading.  This is not to say there won’t be minor corrections or occasional flash crashes due to the asinine techno geek trading systems that now dominate the markets.

We could be wrong.   Godot may just show up tomorrow.

Posted in Monetary Policy, Uncategorized | Tagged , | 1 Comment

Will France Launch The Molotov Cocktail?

The Oat-Bund 10-year spread came in almost 10 bps last week.  The Euro rallied a little over 1 percent.

A disillusioned and highly undecided French electorate head to the polls tomorrow to choose the two candidates (unless one wins an unprecedented 50 percent) for the May 7th second round election, which will decide the country’s next president.    The question is in the privacy of the polling booth will the disaffected marginal French voter decide to launch a political Molotov cocktail, as the Americans did in November, at the system that they deem has failed them and cast their vote for both extreme candidates –  the hard right, Marine Le Pen,  and the hard left, Jean-Luc Mélenchon?

Possible,  but unlikely, in our opinion.

However, the latest polling puts all four candidates almost within the margin of error and with 25 percent of the electorate undecided it makes for much uncertainty and sets the stage for high drama on a Sunday night in Paris.

The first round of voting is set to be a closely-fought race, with the latest poll from PrésiTrack OpinionWay / ORPI for Les Echos and Radio Classique putting the top four candidates within just four points of each other.

Emmanuel Macron, the centre-right pro-EU candidate, leads the poll with 23 per cent.  Marine Le Pen, who has vowed to freeze immigration and end the Schengen agreement, is just one point behind.

Francois Fillon is just behind on 20 per cent, with far-left firebrand Jean-Luc Mélenchon is on 19 per cent.

…With a margin of error of up to 2.2 per cent, and many French voters still undecided, it is possible that any of these four candidates could win the first round of voting.  – Sunday Express

Our sense is Le Pen will probably receive a slightly higher than expected vote due to the “Bradley Effect” and Macron will finish close behind.   This is our educated guess.   Only a guess and could cause a little volatility before French and European financial assets begin to rise — probably by a lot — as they price in a Macron victory in the second round.

Place your bets.

Oat-Bund Yield Spread

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US Sector ETF Performance – April 21


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Global Risk Monitor – April 21

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COTD: Oil Supply Breakeven Prices

Hot from the latest International Monetary Fund’s, World Economic Outlook.   Looks like not many of the projects out there making money at $50 bbl.

IMF_WEO_Oil Breakevens_April20

(COTD = Chart of the Day)

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French Oat-German Bund 10-year Spread

The Oat-Bund yield spread widened out about 7 bps this past week.  Hard left anti-EU candidate, Jean-Luc Mélenchon,  is making a late charge turning the first round of the presidential election into a 4-way horse race.    Though  Le Penn and Macron are ahead in the polls and favored to make the second round,  their leads are just outside the margin of error.   And 33 percent of French voters are still undecided.

Mélenchon-Le Pen second round run-off would really spike volatility as the center would be up for grabs,  increasing the probability of a Le Pen or Melenchon anti-EU presidency and thus an existential threat to the Eurozone and EU.

The favourites to make the second-round runoff on 7 May remain far-right Front National candidate Marine Le Pen and the independent centrist Emmanuel Macron. But with up to one-third of France’s 47 million voters undecided, and another 30% so disillusioned with French politics that they say they will abstain, the field is still wide open.

Two months ago any suggestion that Mélenchon, head of La France Insoumise (Unbowed France), could be a serious contender for the Elysée would have been thought laughable. Now it is no joke. Mélenchon’s popularity is running level with the beleaguered, scandal-hit Fillon in some polls, higher in others.

Le Monde says France is in the unusual situation of having four presidential candidates, any one of whom could win. Like Le Pen, Mélenchon is appealing to young voters with his hologram meetings, his upbeat election messages and his entertainingly forthright approach to televised debates. – The Guardian


Oat-Bund Yield Spread


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US Sector ETF Performance – April 14


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Global Risk Monitor – April 14

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Why the Equity Bull Market Must Continue

We have been busy crunching some very interesting data on pension funds from the most recent Federal Reserve’s,  Flow of Funds Accounts.    Check out the charts below.

Interestingly,  the last time Private and State & Local Government Pensions were fully funded was at the end of the stock market bubble in 2000.  Pensions were 25 percent overfunded in 1999.

However,  even with stocks making new highs,  these pensions remain $2.33 trillion, or 27 percent of their assets,  underfunded at the end of 2016.   Surprising.

One would think the slope should be headed south as stocks rise, no?  Just as it was from 1995 to 2000.   On the contrary,   unfunded entitlements are heading parabolic north.

Could be a combination of low interest rates,  an under-allocation to equities since the and financial crash (see charts) and rising pension entitlements,  mainly in state and local government retirement funds.   Probably more the result of the later.

The Upshot?   It seems the only way out of the pension mess — other than massive contributions, tax increases, or defaults — is a humungous equity bull market with pensions appropriately positioned.   In aggregate, they seem to be gun shy after the financial crisis with their average aggregate equity allocation only about 50 percent of what it was at the start and first few years of the new millennium.

One caveat is the allocation data can be distorted and deceiving as equities are measured at their market value where some of the other assets are not.

The question is:  Will Janet Yellen and President Trump do “whatever it takes to preserve” the pensions?   And will it be enough?

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How the Life Insurance Industry Invests

Life Insurance Company Investments_FoF

Life Insurance Assets_FoFLife Insurance Assets GrowthLife Insurance Equity and Bond Growth_FoF

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