Wednesday, September 25, 2019

As Germany Sinks, Draghi Promotes MMT

Germany's Homegrown Problems. IHS Markit has released its flash estimates for September’s Purchasing Managers’ Indexes (PMIs) in the Eurozone along with those for France and Germany. The German data were downright ugly. There’s no oomph or oompah in Germany. Instead, manufacturing has fallen into a recession and is dragging down the rest of the economy. Real GDP edged down 0.3% (saar) during Q2 and is up just 0.4% y/y (Fig. 1). Another q/q decline is likely during Q3.

In the Eurozone, Markit estimates that the Composite PMI (C-PMI) fell from 51.9 during August to 50.4 this month (Fig. 2). The drop was led by the Manufacturing PMI (M-PMI), which is down from a recent peak of 60.6 during December 2017 to 45.6 this month. However, the Nonmanufacturing (NM-PMI) also contributed to the month’s decline, falling from 53.5 to 52.0. Germany stands out with an M-PMI that is now down to 41.4 compared to 50.3 in France (Fig. 3). Also weakening in Germany is the NM-PMI, which is down from this year’s high of 55.8 during June to 52.5 in September (Fig. 4).

I’ve previously observed that there is something wrong with Germany’s economy. Trump’s trade wars may be part of the problem, but Germany—along with most of the rest of the world—has a serious homegrown problem: not enough babies and too many seniors. Babies tend to stimulate consumption as they grow older, while old people don’t stimulate much of anything. It’s hard to stimulate people who are already old to do much of anything.

That may explain the weakness in global auto sales in recent years (Fig. 5). Germany’s manufacturing economy is particularly dependent on the auto industry. Let’s have a closer look at Germany’s economy:

(1) Tougher emission standards. In the Eurozone, regulators made things worse for the industry with new emission standards imposed a year ago. The new EU-wide test procedure was the authorities’ reaction to VW’s 2015 admission to widescale cheating on diesel vehicles, with suspicions since spreading to other manufacturers.

(2) Losing cache. Germany’s high-performance and high-priced Bimmers and Benzes may not be as popular with Millennials around the world as they were with the Baby Boomers. Millennials tend to be minimalists. They are more concerned about fuel economy and are likely to favor electric vehicles once EVs become cheaper and have more range.

(3) Competing with Chinese EVs. A 9/20 Bloomberg article titled “China Is Winning the Race to Dominate Electric Cars” hits on several of the issues plaguing Germany’s automakers. For starters: “The global auto market is not only not growing, but it is also shrinking. Sales peaked in 2017 at nearly 86 million on a trailing-12-months basis; right now in 2019, sales are closer to 76 million.”

The future for the auto industry is EVs, which are mostly made in China: “There is only one company in the top 10 by percent of electric passenger vehicle revenue that isn’t Chinese: Japan’s Mitsubishi Corp. Two Chinese automakers get more than 40% of revenue from electric vehicle sales; a third gets nearly a quarter of its revenue from EVs.”

(4) Fiscal stimulus coming? In August, German Chancellor Angela Merkel said she sees no need for a stimulus package “so far” but added that “we will react according to the situation.” She pointed to plans to remove the so-called solidarity tax, an added income tax aimed at covering costs associated with rebuilding the former East Germany, for most taxpayers.

(5) Green new deal. The problem is that the government plans to spend $60 billion through 2030 on green new deals, which are more likely to weigh on the economy than to stimulate it. According to the 9/20 WSJ article on this subject:

“The measures, including subsidies for green power generation, will be financed by revenues from higher taxes on polluting activities, such as air travel and car fuel, as well as a new carbon emission certificate trading scheme to be launched in 2021. The package won’t affect Germany’s balanced budget. Despite international pressure on Berlin to loosen the purse strings and revive a slowing economy, the country’s budget surplus is projected to stand at over €40 billion in 2019.”

The government will help to finance more than a million charging stations for EVs by 2030. Owners and buyers of EV cars will get government subsidies, which might further depress gasoline-powered auto sales.

Draghi Saying Give MMT a Chance. Outgoing ECB President Mario Draghi told European lawmakers that Modern Monetary Theory (MMT) should be considered to stimulate the slowing economy of the Eurozone. “It’s a government decision, not [that of] the central bank,” he said. During his tenure, Draghi’s monetary policy commitment to “do whatever it takes” to save the Eurozone economy hasn’t been enough, so I am not surprised that before his 10/31 departure he is calling on fiscal policy to save the day.

The basic tenet of MMT is that a government may borrow and spend to infinity and beyond because it controls the creation of money. Under MMT, governments can never run out of money to pay their debts, say MMT advocates. They would only cease MMT if inflation heated up.

On his way out the door, Draghi set the stage for MMT in the Eurozone by lowering the ECB's official deposit rate from -0.40% to -0.50% and restarting the asset-purchase program. The ECB is set to buy €20 billion per month in Eurozone securities, including government bonds.

It is unlikely that German leaders will readily take the advice of the ECB, let alone its outgoing president, to consider an idea like MMT. Officials of the EU’s largest economy deeply value fiscal discipline. They undoubtedly will protest that MMT violates the principles of the Maastricht Treaty, the official treaty on the European Union signed in 1992, which emphasizes sound fiscal policies and limits on debt.

Thursday, September 12, 2019

US Bond Yields Made in Germany

Another round of central bank easing is underway. So why are bond yields rising?

The 10-year US Treasury bond yield rose from a recent low of 1.47% on 9/4 to 1.72% on Tuesday (Fig. 1). The record low was 1.37%, hit on 7/8/16 just after the Brits voted to leave the European Union (EU). The risks of a no-deal Brexit have eased in recent days, though it still could happen next month. A hard Brexit could cause the bond yield to retest its recent low.

In any event, the main reason that the US bond yield has moved higher in recent days has more to do with Germany than the UK. The 10-year German government bond yield has risen from a recent record low of -0.71% on 8/30 to -0.54% Tuesday. Reuter’s reported: “Germany’s 30-year government bond yield briefly rose into positive territory on Tuesday for the first time in over a month, lifted by expectations for fiscal stimulus and caution over the scale of stimulus the European Central Bank might deliver this week.”

During a parliamentary budget debate on Tuesday, Germany’s Finance Minister Olaf Scholz said that Germany can counter a possible recession with a big stimulus package. On Monday, Reuters reported that Germany was considering creating a “shadow budget” to boost public investment above and beyond limits set by its national debt rules, sparking a bond sell-off.

European Central Bank (ECB) President Mario Draghi has been lobbying for fiscal policy to turn more stimulative to support the ECB’s ultra-easy monetary policies. Germany has resisted doing so and even questioned whether the ECB’s asset purchase program could legally buy sovereign bonds. Germany’s fiscal and monetary conservatives might be starting to waver as a result of Germany’s intensifying manufacturing recession, with factory orders and production down 5.6% and 4.8% y/y through July (Fig. 2).

Last year, when there was widespread bearishness in the bond market, with some predicting that the US yield would rise from 3% to 4%-5%, I observed that the US bond yield might be “tethered” to the comparable German and Japanese yields, which were barely above zero. This year, both have dropped solidly below zero.

During the Q&A portion of his 7/25 press conference, Draghi pleaded for more fiscal stimulus, especially from Germany:

“What’s hitting the manufacturing sector in Germany and [elsewhere in Europe is] an idiosyncratic shock. Here what becomes really very important is fiscal policy. [T]he mildly expansionary fiscal policy is supporting activity in the euro area. But if there were to be a significant worsening in the Eurozone economy, it’s unquestionable that fiscal policy … becomes of the essence. … I started making this point way back in 2014 in a Jackson Hole speech: monetary policy has done a lot to support the euro area … but if we continue with this deteriorating outlook, fiscal policy will become of the essence.”

Thursday, September 5, 2019


I visited with our accounts in Atlanta and Chattanooga recently. They seemed relatively calm. Most of them believe that the US economy can continue to grow for the foreseeable future. So they aren’t freaking out about the recent inversion of the yield curve. However, they are somewhat anxious about the prospect of negative interest rates in the US, though they think it is a remote possibility. Consider the following:

(1) US bond yields stand out. We discussed in our meetings the expectation that the Bank of Japan (BOJ) is likely to keep its official policy interest rate at -0.10% for the foreseeable future, as it has since 1/29/16, while the Governing Council of the European Central Bank (ECB) is likely to lower its official deposit rate, currently -0.40%, deeper into negative territory at its 9/12 meeting (Fig. 1). The ECB is widely expected to resume quantitative easing at that meeting as well (Fig. 2).

Such expectations have driven the 10-year German government bond yield down to -0.70% on Monday from 0.24% at the start of this year. At 1.50% on Friday, the 10-year US Treasury bond yield is literally outstanding compared to the comparable yields available overseas: UK (0.34%), Japan (-0.27), Sweden (-0.34), France (-0.40), Germany (-0.70) (Fig. 3). The negative-interest-rate policies (NIRPs) of the ECB and BOJ are increasing the amount of negative-interest-rate bonds (NIRBs) around the world.

(2) Dividend & earnings yields stand out. The rationale for remaining bullish on US stocks seems to be shifting from TINA (there is no alternative) and FOMO (fear of missing out) to FONIR (fear of negative interest rates). These fears are inherently bullish for stocks and continue to overcome the bearish fear that an inverted yield curve is predicting an impending recession, i.e., FOIYC (fear of inverted yield curve).

A few of the accounts with whom I met recently noted that the 10-year US Treasury bond yield at 1.50% is below the S&P 500 dividend yield, at 1.90% during Q2-2019 (Fig. 4). That is one very good reason why they remain mostly fully invested in the stock market. I observed that the forward earnings yield of the S&P 500, at 6.06% during August, is even more outstanding compared to the bond yield (Fig. 5).

(3) Performance derby. The 119bps drop in the US bond yield since the beginning of the year certainly has benefited dividend-yielding stocks. The S&P 500 sectors that tend to have lots of dividend-paying companies have outperformed those that tend to have fewer of them: Information Technology (28.0% ytd), Real Estate (26.0), Consumer Discretionary (20.3), Communication Services (20.0), Consumer Staples (19.0), Utilities (17.6), Industrials (17.4), S&P 500 (16.7), Financials (12.6), Materials (11.9), Health Care (4.6), and Energy (-0.5) (Fig. 6).

FONIR should continue to benefit dividend-yielding stocks. Their high valuation multiples reflect investors’ willingness to pay up for these stocks, as evidenced by the relatively high forward P/Es of the S&P 500 sectors with lots of dividend payers: Real Estate (44.0), Consumer Discretionary (21.2), Information Technology (19.6), Consumer Staples (19.6), Utilities (19.4), Communication Services (17.4), Materials (16.9), S&P 500 (16.8), Industrials (15.4), Health Care (14.8), Energy (14.7), and Financials (11.4) (Fig. 7).

(4) Real yields. During July, the US bond yield averaged 2.05%, while the CPI inflation rate was 1.80%. So the inflation-adjusted bond yield was close to zero, at 0.25% (Fig. 8). During August, the bond yield fell below the inflation rate. In other words, in real terms, bond yields are entering negative territory. Meanwhile, the real earnings yield of the S&P 500, using reported earnings, remained solidly in positive territory during Q2-2019, at 3.02% (Fig. 9). The real forward earnings yield of the S&P 500 was 4.03% during July (Fig. 10).