This commentary does focus on the state of the potential reflation trade at quarter end and our suspicion it won’t work out as some investors hope. We have also written on India as the end because we felt obliged to comment on some excellent research we read this week.
For a good part of the first quarter, we have noted that not all was well with either the global reflation trade nor the inflation narratives that took hold post the US election. We pointed out that the immediate post Brexit collapse in bond yields was a market over reaction (hat tip to Julian Brigden at MI2 Partners) and that the subsequent bounce, or reflation, began in Q3 before the US election (i.e. nothing to do with Trump to begin with).
Of course, Trump’s victory and an evaluation of his policy proposals, gave the reflation narrative a tremendous boost. But our view from the beginning was that Trump’s policies would fail to ignite the real economy, and frankly, the signs that the market is less than convinced have been increasing since January. Some of what we show below you will have seen before, but we believe is important nonetheless.
Let’s start with a quick look at US inflation. Chart 1 below shows several different measures of inflation as well as a widely accepted measure of Wage Growth. We wrote earlier in the year how the low base effect from oil prices a year ago would mean that inflation peaks in Q1. There may be an Easter timing effect (last year Easter fell in March whereas this year it falls in April) but in the big picture we think that the rise in inflation has pretty much played out, with one caveat. If wages can increase in the months ahead, then there could be an argument that we are now in a period of generally higher inflation that has been seen in recent years. That said, the Atlanta Fed Wage Tracker is at the same level as it was two years ago. We therefore need to watch wages closely in the months ahead, but we suspect that this measure needs to show wages growing nearer to 4% for inflation to remain above 2%.
Chart 1 – Various US Inflation Measures
As regards real economic growth, the hype (both from the White House and the business/consumer surveys) is currently better than the reality. With Q1 now over, the Government bean counters will be beavering away to produce their first estimate of US growth at the end of April. Street estimates are for about 2% whereas the Atlanta Fed GDPNow model is predicting that growth was about 1%.
Chart 2 below shows the recent performance of US GDP. If the Q1 outcome is in line with Street estimates, it will be the second quarter in a row of deceleration. If the outcome is nearer to the Atlanta Fed model, then growth will be at the low end of the range for the last few years. The main point here is that economic growth is not accelerating, and will not do so without some exogenous force that will increase productivity or immigration or both. Of course, this mainly relates to new policies introduced by the new administration, and here, we simply have to wait for news.
Chart 2 – Real US Gross Domestic Product
We noted a few weeks ago that bank lending in the US was slowing down quite sharply, and that process continues. The 6 month annualised percentage change in lending for all loans & leases and commercial and industrial loans is collapsing as can be seen in chart 3. Simplistically, when we take account of the tightening in lending standards at banks, the lower demand for loans and a Fed that is raising interest rates, this does not support the narrative of an economy accelerating 8 years into the current expansion. In fact, we believe that the current expansion is very mature, and that the recent higher inflation trajectory and the typical Fed response are all signs that we are closer to the next recession than economic nirvana.
Chart 3 – US Bank Lending
So, given the above, we are very much disposed to lean against the current inflation and reflation narratives. In fact, we have been of that persuasion for most of the first quarter, and we are simply increasing our conviction levels.
In recent weeks, we have been emphasising how the US bond market has simply not been buying into the reflation narrative, as measured by longer dated yields, the shape of the yield curve and future inflation expectations. Chart 4 below shows the US 10 year bond yield (in white) alongside the 5 year 5 year forward inflation expectation (in red) and the shape of the yield curve as measured by the difference between the 10 year and 2 year bonds (in green).
We have also highlighted a shelf of support in both the 10 year bond and the 5 year 5 year forward inflation expectations. With the rate of inflation peaking in Q1, continued moribund growth, decelerating bank lending and the Fed now tightening policy, we think the odds are that all three move lower in the months ahead. This technical view is supported by demographic shifts. As noted recently, these shifts support an allocation away from risky assets to more defensive assets that generate a safe yield.
Chart 4 – US Yields
In terms of equities, back on 12th March with the S&P 500 at 2372, we highlighted how overbought US equities were technically and that a period of consolidation should be expected at a minimum. With the S&P closing at 2362 last week, the price action since has seemingly consolidated. We continue to maintain that US equities are extremely expensive, but we need more technical evidence that a turn lower is occurring.
One last section this week, which we will place under the headline “if you can’t be smart yourself, then try and surround yourself with smart people”. We do subscribe to some external research sources, and we regularly quote from them in our commentaries. Generally speaking, we see our external research providers as generating high quality research, and occasionally we see something that totally turns our thinking upside down. Well, this past week, we saw some research that completely changed our thinking on India.
John Mauldin produces lots of excellent research, some of it from his own resources and some of it from his friends. Raoul Pal managed to retire at the age of 36 having worked in banks and a large hedge fund. He is a clever guy and John Mauldin shared a piece of research from Raoul in which he seems to have picked up on something in India that has gone unnoticed by that vast majority of people, us definitely included.
By way of background, on the 8th November last year, the Indian Government announced that they were getting rid of high denomination bank notes such that cash would become a much smaller part of the economy. Our initial take was that this was a bad move, a way for the Government to control the economy and people’s lives more closely. The early evidence seemed to point that way as the disruption did have an impact on the economy. However, having read Raoul Pal’s research, we have changed our mind.
To whet the appetite, Raoul states “India has, without question, made the largest technological breakthrough of any nation in living memory.”
The story begins in 2009 when the Government embarked on a project that would bring everyone into the mainstream economy. For the most part, India is an agrarian economy in which hundreds of millions of people are simply not able to prove their identity and therefore were not able to open a bank account, get a driving licence, a loan or insurance. They were basically operating outside of the official economy which means that they could not get a better paying job, pay taxes and generally benefit from and contribute to society.
This project was a technological solution to the problem, creating a biometric database based on a 12-digit digital identity, authenticated by finger prints and retina scans. Project Aadhaar became the largest and most successful IT project ever undertaken in the world and, as of 2016, 1.1 billion people (95% of the population) now has a digital proof of identity.
Having successfully built the technology platform to bring the population into the mainstream, the Government created 11 new banks to offer basic banking to the population, and within three years more than 270 million bank accounts have been opened and US$10 billion in deposits flooded in. The Government also made it possible for those registered under project Aadhaar to open a mobile phone account, and since this time, mobile phone penetration has jumped from 40% to 79%.
Now that the population can be brought into the mainstream, open a bank account and get a mobile phone, the Government has to upgrade the technology again, and it is working with the biggest global technology companies to do so. This is already possible on the existing 2G networks, but will be improved. At the end of 2016, the Government launched new digital payments platform that will allow payments to be made using finger prints alone.
Basically, within a few short years, India has built a technology platform that has brought nearly their entire population into the mainstream, allowed them to open a bank account and get a mobile phone and soon make payments just using finger prints. As Raoul colourfully says “Fucking hell. That is the biggest change to any financial system in history…But again, that is not all… India has gone one step further…”
In 2016, India introduced another innovation called India Stack. This is a series of secured and connected systems that allows people to store and share personal data such as addresses, bank statements, medical records, employment records and tax filings and it enables the digital signing of documents. This is all accessed, and can be shared, via Aadhaar biometric authentication.
And so back to where we got it so wrong; the cash ban. We thought it was a bad move, but we simply did not know it was the final part of a grand plan that just makes so much sense, or in the words of Raoul “The final stroke of genius was the cash ban, which I have also discussed at length in the past. The cash ban is the final part of the story. It simply forces everyone into the new digital economy and has the hugely beneficial side-effect of reducing everyday corruption, recapitalising the banking sector and increasing government tax take, thus allowing India to rebuild its crumbling infrastructure…”
Now, although we think Raoul Pal is a very clever chap, we will be doing more research ourselves to verify what seems to be an amazing investment opportunity for long term investors. Our simple view had been that India, with a mainly agrarian population of 1.3 billion people, was a country with huge potential but also huge problems. Indeed, some of the problems remain, but this new technology platform, and the way they keep developing it, completely changes our view. India could very well become the biggest investment opportunity for the next decade or two, and as such, we have immediately invested some funds into their equity market, and will look to increase our commitment over time.
Stewart Richardson
RMG Wealth Management
