Excerpted from Hoisington Investment Management's Quarterly Outlook,
via Van Hoisington and Lacy Hunt:
The U.S. economy continues to lose momentum despite the Federal Reserve’s use of conventional techniques and numerous experimental measures to spur growth. In the first half of the year, real GDP grew at only a 1.2% annual rate while real per capita GDP increased by a minimal 0.3% annual rate. Such increases are insufficient to raise the standard of living, which, as measured by real median household income, stands at the same level as it did seventeen years ago.
Historically, in our judgment, the most important authority on the subject of asset bubbles was the late MIT professor Charles Kindleberger, author of 20 books including the one of the greatest books on capital markets Manias, Panics and Crashes (1978). He found that asset price bubbles depend on the growth of credit. Atif Mian (Princeton) and Amir Sufi (University of Chicago) provided confirmation for Kindleberger’s pioneering work and expanded on it in their 2014 book House of Debt. Chapter 8, entitled “Debt and Bubbles,” contains the heart of their insights. Mian and Sufi demonstrate that increasing the flow of credit is extremely counterproductive when the fundamental problem is too much debt, and excessive debt can fuel asset bubbles.
Based on our reading of these two books we would define an asset bubble as a rise in prices that is caused by excess central bank liquidity rather than economic fundamentals. As Kindleberger clearly stated, the process of excess liquidity fueling higher prices in the face of faltering fundamentals can run for a long time, a phase Kindleberger called “overtrading”. But eventually, this gives way to “discredit”, when the discerning few see the discrepancy between prices and fundamentals. Eventually, discredit yields to “revulsion”, when the crowd understands the imbalance, and markets correct.
Economists have commented on the high correlation between the S&P 500 and the Fed’s balance sheet since 2009. From 2009 to the latest available month, the monetary base (MB) surged from $1.7 trillion to $4.1 trillion. We ran the MB increase against the S&P 500 and found a very high correlation of 0.69. While correlation does not prove causality, the high correlation is certainly not inconsistent with the idea that the Fed liquidity played a major role in boosting stock prices. However, even as the MB has exploded since 2009 and stock prices have soared, the U.S. economy has experienced the worst economic expansion on record. In spite of a further large rise in the base this year, the GDP growth has subsided noticeably and corporate profits after taxes and adjusted for inventory gains/losses (IVA) and over/under depreciation (CCA) has declined 10% in the latest four quarters. Such discrepancy between the liquidity implied by the base and measures of economic performance could indicate the process of bubble formation. Kindleberger’s axiom that asset price bubbles depend on excess liquidity may yet face another test.
Still Bullish on Treasury Bonds
With the nominal growth trajectory extremely soft, U.S. Treasury bond yields are likely to continue working lower as similar circumstances have created declines in government bond yields in Europe and Japan. Viewing the yields overseas, it is evident that ample downside still exists for long U.S. Treasury bond yields, as the higher U.S. yields offer global investors an incentive to continue to move funds into the United States.
Another factor suggesting lower longterm U.S. Treasury yields is the strength of the U.S. dollar. In many industries, the price leader for certain goods in the U.S. is a foreign producer. A rising dollar leads to what economists sometimes call the “collapsing umbrella”. As the dollar lifts, the foreign producer cuts U.S. selling prices, forcing domestic producers to match the lower prices. This reinforces the prospect for lower inflation as nominal GDP wanes. This creates a favorable environment for falling U.S. Treasury bond yields.
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