The Hoisington Investment Management, Second Quarter 2014 Review and Outlook makes the case “Treasury Bond Undervalued“.
Thirty-year treasury bonds appear to be undervalued based on the tepid growth rate of the U.S. economy. The past four quarters have recorded a nominal “top-line” GDP expansion of only 2.9%, while the bond yield remains close to 3.4%.
To put the 2.9% change in nominal GDP over the past four quarters in perspective, it is below the entry point of any post-war recession. Even adjusting for inflation the average four-quarter growth rate in real GDP for this recovery is 1.8%, well below the 4.2% average in all of the previous post-war expansions.
Fisher’s Equation of Exchange
Slow nominal growth is not surprising to those who recall the American economist Irving Fisher’s (1867-1947) equation of exchange that was formulated in 1911. Fisher stated that nominal GDP is equal to money (M) times its turnover or velocity (V), i.e., GDP=M*V. Twelve months ago money (M) was expanding about 7%, and velocity (V) was declining at about a 4% annual rate. If you assume that those trends would remain in place then nominal GDP should have expanded at about 3% over the ensuing twelve months, which is exactly what occurred. Projecting further into 2014, the evidence of a continual lackluster expansion is clear. At the end of June money was expanding at slightly above a 6% annual rate, while velocity has been declining around 3%. Thus, Fisher’s formula suggests that another twelve months of a 3% nominal growth rate is more likely than not. With inflation widely expected to rise in the 1.5% to 2.0% range, arithmetic suggests that real GDP in 2014 will expand between 1.0% and 1.5% versus the average output level of 2013. This rate of expansion will translate into a year-over-year growth rate of around 1% by the fourth quarter of 2014. This is akin to pre-recessionary conditions.
An Alternative View of Debt
The perplexing fact is that the growth rate of the economy continues to erode despite six years of cumulative deficits totaling $6.27 trillion and the Federal Reserve’s quantitative easing policy which added net $3.63 trillion of treasury and agency securities to their portfolio. Many would assume that such stimulus would be associated with a booming economic environment, not a slowing one.
Readers of our letters are familiar with our long-standing assessment that the cause of slower growth is the overly indebted economy with too much non-productive debt. Rather than repairing its balance sheet by reducing debt, the U.S. economy is starting to increase its leverage. Total debt rose to 349.3% of GDP in the first quarter, up from 343.7% in the third quarter of 2013.
It is possible to cast an increase in debt in positive terms since it suggests that banks and other financial intermediaries are now confident and are lowering credit standards for automobiles, home equity, credit cards and other types of loans. Indeed, the economy gets a temporary boost when participants become more indebted. This conclusion was the essence of the pioneering work by Eugen von Böhm-Bawerk (1851-1914) and Irving Fisher which stated that debt is an increase in current spending (economic expansion) followed by a decline in future spending (economic contraction).
In concert with this view, but pinpointing the negative aspect of debt, contemporary economic research has corroborated the views of Hyman Minsky (1919-1996) and Charles Kindleberger (1910-2003) that debt slows economic growth at higher levels when it is skewed toward the type of borrowing that will not create an income stream sufficient to repay principal and interest.
John Maynard Keynes (1883-1946) correctly argued that the severity of the Great Depression was due to under-consumption or over-saving. What Keynes failed to note was that the under-consumption of the 1930s was due to over-spending in the second half of the 1920s. In other words, once circumstances have allowed the under-saving event to occur, the net result will be a long period of economic under-performance.
Implications for 2014-2015
In previous letters we have shown that the largest economies in the world have a higher total debt to GDP today than at the time of the Great Recession in 2008. PSRs [Personal Savings Rates] also indicate that foreign households are living further above their means than six years ago. According to the OECD, Japan’s PSR for 2014 will be 0.6%, virtually unchanged from 2008. The OECD figure is likely to turn out to be very optimistic as the full effects of the April 2014 VAT increase takes effect, and a negative PSR for the year should not be ruled out. In addition, Japan’s PSR is considerably below that of the U.S. The Eurozone PSR as a whole is estimated at 7.9%, down 1.5 percentage points from 2008. Thus, in aggregate, the U.S., Japan and Europe are all trying to solve an under-saving problem by creating more under-saving. History indicates this is not a viable path to recovery.
Japan confirms the experience in the United States because their PSR has declined from over 20% in the financial meltdown year of 1989 to today’s near zero level. Japan, unlike the U.S. in the 1940s, has moved further away from financial stability. Despite numerous monetary and fiscal policy maneuvers that were described as extremely powerful, the end result was that they have not been successful.
With U.S. rates higher than those of major foreign markets, investors are provided with an additional reason to look favorably on increased investments in the long end of the U.S. treasury market. Additionally, with nominal growth slowing in response to low saving and higher debt we expect that over the next several years U.S. thirty-year bond yields could decline into the range of 1.7% to 2.3%, which is where the thirty-year yields in the Japanese and German economies, respectively, currently stand.
Van R. Hoisington
Lacy H. Hunt, Ph.D.
Reflections on Keynesian Analysis
Unlike the Hoisington authors, I have no praise at all for Keynes. That said, Hoisington politely blasts Keynes in this snip: “Keynes failed to note was that the under-consumption of the 1930s was due to over-spending in the second half of the 1920s. In other words, once circumstances have allowed the under-saving event to occur, the net result will be a long period of economic under-performance.“
I like the discussion on personal savings rates, especially this comment: “In aggregate, the U.S., Japan and Europe are all trying to solve an under-saving problem by creating more under-saving. History indicates this is not a viable path to recovery.“
Path to Fiscal Ruin
The OECD predicts Japan’s PSR for 2014 will be 0.6%, but Hoisington points out that assessment is “likely to turn out to be very optimistic as the full effects of the April 2014 VAT increase takes effect. A negative PSR for the year should not be ruled out.”
The US and Japan are both on the path of fiscal ruin. It appears highly likely Japan will get there first thanks to a big head start followed by Abenomics.
Yesterday, in Corporate and Government Bonds: Where to From Here? and in sharp contrast to all of those who see a US treasury bond bubble, I stated: “The worry about US government bonds is, for the time, overblown.“
Hoisington provides much analysis that shows why my statement is correct. There is much more in the article and it merits a full read. Ignore any positive references to Keynes, but accept all of the negative ones, and the article reads perfectly.
I am in Glacier National Park, Montana (to be more precise, just outside the park). There is no phone or internet in the park. It can take 1 hour to do an email on the park satellite Wi-Fi.
Liz and I went on a 10 mile round-trip hike to Iceberg Lake. It has about a 1,200 foot elevation change, all up on the way to the lake, all down on the way back. Here are a couple of images.
Iceberg Lake Closeup
Mike “Mish” Shedlock