Quarterly Review and Outlook
Comment of the Day

April 24 2018

Commentary by Eoin Treacy

Quarterly Review and Outlook

Thanks to a subscriber for this report from Hoisington Investment Management which doubles down on a bullish bond view. Here is a section:

The law of diminishing returns is already evident in all major economies as well as on a global scale (Table 1). Global GDP generated per dollar of total global public and private debt dropped from 36 cents in 2007 to just 31 cents in 2017. Diminishing returns is even more apparent in the case of China’s public and private debt, largely internally owned. In terms of each dollar of debt, China generated 61 cents of GDP growth in 2007 and only 33 cents last year. In other words, in the past ten years the efficiency of China’s debt fell 45%. Thus, even in a command and control economy, the law of diminishing returns prevails. The most advanced sign of diminishing returns is in Japan, the most heavily indebted major country, where a dollar of debt in the last year produced only 22 cents of GDP growth. This economic principle applies equally to businesses.

All economies rely heavily on the business sector to lead the growth process. Yet, a sharp decline in GDP per dollar of business debt occurred in the U.S. during the past nine years, reinforcing the underlying trend since the early 1950’s. In 1952, $3.42 of GDP was generated for every dollar of business debt, compared with only $1.39 in 2017. In the corporate sector, where capital as well as technology is most readily available, GDP generated per dollar of debt fell from $4.50 in 1952 to $2.50 in 2007 to $2.21 last year. The dismal trend in productivity confirms this conclusion. The percent change for productivity in the last five years (2017-2012) was equal to the lowest of all five-year spans since 1952. It was also less than half the average growth over that period.

Conclusion Important to the long-term investor is the pernicious impact of exploding debt levels. This condition will slow economic growth, and the resulting poor economic conditions will lead to lower inflation and thereby lower long-term interest rates. This suggests that high quality yields may be difficult to obtain within the next decade. In the shorter run, in accordance with Friedman’s established theory, the current monetary deceleration, or restrictive monetary policy, will bring about lower long-term interest rates.

Eoin Treacy's view

Here is a link to the full report.

This is the most commonly espoused view for why bond yields cannot rise. After all, with so much debt, the potential for growth to underperform and quantitative tightening there is a logical argument for why interest rates should stay lower for longer. However, there are other factors at work which this view does not take account of.

The very law of diminishing returns that the bullish camp holds to is the enemy of the status quo persisting indefinitely. The reason yields tested 3% today is because there is so much additional supply queued up on top of the refinancing calendar already expected. The most basic law of supply and demand is when supply increases by an order of magnitude without a similar jump in demand, then prices should come down.

Meanwhile rising yields, against a background of modest growth, raises the spectre of stagflation. Economic contraction would likely be required to act as a meaningful tailwind for bonds.

Meanwhile the stock market’s intraday volatility has picked up meaningfully since the initial February pullback which is traumatic for investor sentiment. Today’s sharp pullback takes the major Wall Street indices back to test their respective trend means and they will need to rally soon if support is to be confirmed in the region of their lows.

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