State of Capital: Vol.1

The third quarter of the year saw a revised reading of Gross Domestic Product of 3.3%, while the second quarter read 3.1%. Unemployment fell to 4.1% in October. The US stock market if off to new highs as is bitcoin. Inflation edged up to 1.8% after five months stuck at 1.7%. In fact, inflation, as measured by the NY Fed’s underlying gauge, is nearing 3%. Consumer confidence remains at a 17 year high. These headline numbers in the US bode well for overall economic strength and footing. Behind the curtain there is a slightly different story.


1. Yield Curve

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59 basis points. That is the spread of the yield curve, as measured by the 10 year treasury bond minus the two year treasury. The spread between the two keep falling. To be clear, a flatter-than-usual yield curve, like one we see now, is not necessarily a death sentence, but it does not bode well for credit expansion through intermediaries. What bank would want to receive a net of 0.59% for lending ten years from borrowed money to be paid in two. I’m sure not many are thrilled at the prospects. If measured inflation does not create more upside pressure on long yields while the Fed continues it’s path of rate increases, a further flattening could occur. This would not be a welcome sign.


2. Junk Spread

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The Junk Spread, as measured by the Bank of America Merrill Lynch US High Yield Option-Adjusted Spread, resides at 3.7%. This means that investors who buy high-yield bonds are accepting 370 basis points above a comparable-maturity Treasury to take on the risk of losing capital. In early 2016, those same investors were offered almost 3x that compensation. To be fair, this was due to the fear of energy companies going under as oil prices fell through the floor. Nevertheless, this does not seem to me to be a fair wage.


3. Market Capitalization vs. Gross Domestic Product

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Much of the credit for this valuation measure has been given to the Oracle of Omaha. When measured against the output of a nation, the dollar value of all publicly-traded stocks can give an indication of the how far ahead market participants have pulled returns from the future, or how little they are valuing prospective returns. Since the early 90’s this measure has been helpful in pointing out when trouble could be ahead. A cyclical peak followed by a downward movement has been the signal to look out for. At the moment, it does not look great, but where did you expect all of this easy money to go? Into consumption? The next reading should give us more clues.


4. Transports


Although we transitioned to a service economy a long time ago, shipping of goods is still a telling indicator of economic momentum. When the aggregate stock value of to shipping stocks starts to lag behind the market as a whole, there may be something to be taken from it. If goods are not being moved across the country from supplier to end-user, it may be a sign that consumers are not demanding services that require goods from suppliers, or that they are not interested or able to buy certain goods. So far, the year-to-date performance of the transports does not support the thesis of a thriving economy. On a side note, perhaps the old stalwarts are being squeezed by new disruptors like Amazon and gig-economy startups who take advantage of excess capacity that exists in the average consumers’ automobile and time.


5. Monetary Policy

Last, and possibly the most influential to the buoyancy of risk assets, is monetary policy. With Jerome Powell taking the reins a the Federal Reserve in the coming months, many are speculating that Janet Yellen’s easy yet dwindling policies will continue.  This, although good for assets in an absolute sense, is relatively bearish for US assets because other leading central banks, namely the ECB and BOJ are still much more loose.

Now, despite homing in on relatively higher rates, money still seems to be easy according to the Chicago Fed’s National Financial Conditions Index. This index does include a measure for equity markets, which could be making it seem easier than it is through the so-called “wealth effect”. Either way, the index shows the easiest financial conditions since the early 90’s.


When speaking of money itself, M1 and the broader M2 can be useful indicators of money getting in the hands of those who are willing to spend. The year-over-year change in M1 and M2 are shown below. Over the last 25 years, whenever M2 starts to grow, and maintains a rate faster rate than M1, it seems as though the second half of the business cycle is solidified.  We are seemingly not there yet.

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The yield curve has been said by many great investors and market observers to be the single most important forward indicator of an economy. It points to a less than healthy future despite many other factors pointing up. GDP is on it’s way up and unemployment is low but perhaps not as helpful an indicator due to the quality of employment. Underlying inflation may be on the rise and money is still cheap. Unfortunately the yield curve is flattening, risk-assets are pushing up on valuations and therefore investors are accepting less risk premium.

This volume of the State of Capital points to a mixed bag of readings; coincident indicators point to current health while forward-looking indicators are less than promising. Remember, the higher the asset price now, the lower the expected return.


Sources: FRED, NY FED, BLS, Conference Board