State of Capital: Vol 2

PDF: State Of Capital Vol. 2


1. Yield Curve

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The yield curve has flattened a hare from our last measurement of 0.59% to 0.53%. In general, an inverted yield curve precedes economic faltering, yet there can be early (technically false) signals. In 1998 a brief trip into negative territory failed to scare hungry futurists from flooding dot-com’s with equity capital for almost another two years. In February of 2006 another early warning flashed as the curve fell below parity due to a rising Fed Funds Rate-that took another 18 months to materialize into something noteworthy.

In nature, the yield curve is anomalous with the growth of borrowing. Structurally, the Fed can entice banks to lend, but only by so much. A bank must feel as though the spread between short and long rates is enough to compensate for risk. Credit creation has been proven to be behind a lions share of growth in our economy which is why it is a critical measure.

While the yield curve tells us something about the prospects of our future, it may not be especially helpful when it comes to timing- it may be more strategic than tactical in usefulness.


2. Junk Spread

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The spread between risky high yield bonds and risk-less treasuries enumerates risk tolerance in the fixed income markets. When investor demand is out-muscling the supply of high yield bonds their price has nowhere to go but up. As is the case for debt instruments, their yields must fall. When this yield, less that of an equivalent government security, is small, it is quite like saying investors do not mind taking an extra unit of risk for less than one extra unit of return.

Although this can be explained away by some using quantitative easing as a structural defense, we see this deterioration of the margin of safety occurring in real time.


3. Market Capitalization vs. Gross Domestic Product

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This chart is worth the views alone. Not too often in the last 30 years has the Market Cap to GDP touched so high, declined and stuck it out for very long. Again, all of these distortions are possibly the doing of the monetary alchemists, but that does not mean that we can brush it aside.

Some attribute this to a stagnant supply of equity shes available due to buybacks and more deals being made in the private equity space. In any case, this situation looks less than positive.


4. Transports

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This one needs further research as to it’s validity on my part, but for the time being, the story checks out; When goods are increasingly being moved around, their chauffeur should be doing well. No serious divergence with this seems evident at the moment.

5. Monetary Policy

The story remains the same at the Federal Reserve: Slow and steady increases as underlying inflation is showing signs of picking up. While Jerome Powell, a non-PhD, steps into office, we could see a sea change though so far he has towed the line.


According to the Chicago Fed’s National Financial Conditions Index, a reading of -0.91 connotes easy financial conditions one standard deviation easier than the norm. This data dates back to 1971.


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The year-over-year percentage change in the velocity of money has been dismal over the last decade. With record liquidity flooding the system, the lack of velocity creates a type of dam siphoning only a small percentage of fiat into the hands of the consumer. As is known, it is the consumer who moves the needle in our economy so until a substantial increase in their wallets is presented in the data, we may stay credit-happy.


Additional Thoughts

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At 2.9%, is the personal savings rate even worth tracking? With lackluster wage growth consumers are relying more on revolving credit to make ends meet. This is not what a discerning economist hopes to see as credit-fueled growth is rather unsustainable. It seems as though the passage of the new tax plan is incensing businesses to raise wages and gave one-time bonuses which, hopefully can counteract this worrying trend.

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If there is a bright side of a sub-3% savings rate it comes in the form of a low debt-servicing cost. Although it cannot last forever-unlike some forms of indebtedness- it makes carrying the burden a bit more manageable. Never mind that it encourages ever more gearing the originators may well bark.

In closing, everything is expensive. Credit spreads are narrow, meaning investors are overpaying for yield. Equity multiples are historically lofty so one would hope that next years earnings projections are relatively correct to counteract this. Safety is hard to come by as there is generally a negative real incentive to hold such securities. In all, not much seems like a bargain with so much money in the system. As the wheels are in motion to reverse this process, I hope, yet would not bet, that a smooth landing is in order.