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    Forward Guidance

    | Alfonso Peccatiello

    Sun Jul 16 2023
    US EconomyCreditBank ReservesMoney PrintingFiscal DeficitsStock Market PerformanceInvestment Considerations

    Description

    The episode covers the current state of the US economy, tighter financing conditions and credit impulse, the impact of credit on the real economy, the role of bank reserves and credit creation, real economy money printing and fiscal deficits, the mechanics of money printing and credit creation, credit creation and bank lending, the relationship between credit and stock market performance, insights and investment considerations, and the investment outlook and market dynamics.

    Insights

    Credit Creation and Real Economy Impact

    The lags in credit and its impact on the real economy are important factors to consider. Assuming that credit doesn't matter is a mistake. The price of credit has increased while its availability has decreased. Credit flows through capital markets and shadow banking should also be considered. The length of the current cycle's lag may be longer due to the massive credit boom. Investors should be aware of these factors when evaluating the state of the economy.

    Bank Reserves and Money Printing

    Bank reserves do not create real economy money. The decision of a corporate to issue more credit is what increases the money in the system. Quantitative easing by central banks leads to a lack of collateral for investment funds. Low volatility and abundant bank reserves can lead to portfolio rebalancing towards credit. The increase in bank reserves by the Bank of Japan did not increase real economy money in circulation.

    Fiscal Deficits and Money Creation

    Real economy money printing happens through fiscal deficits, not quantitative easing. Government deficit spending increases bank deposits and reserves. Europe's underperformance can be attributed to austerity programs. Fiscal deficits not offset by an increase in the treasury general account do not result in increased spending or borrowing. The Federal Reserve can monetize debt by buying treasuries from JP Morgan.

    Credit Creation and Stock Market Performance

    Total credit to the economy has grown over the last 30 years, replacing structural growth with cyclical growth. The belief that high interest rates and quantitative tightening are bad for stocks is challenged by historical examples. Net liquidity explains only a small percentage of S&P 500 returns. A multivariable approach is necessary when evaluating macro models. Changes in bank reserves can explain some changes in earnings and the S&P 500.

    Investment Considerations

    Changes in bank reserves do not correlate well with changes in S&P 500 returns. Banks primarily invest in Treasuries, corporate bonds, and mortgage-backed securities, not stocks. Interest rates impact stock valuations, while inflationary trends and low but predictable growth create opportunities for certain assets. Bonds can provide protection against credit events and disinflationary trends. The timing of a recession is uncertain, but markets will anticipate it before it officially happens.

    Chapters

    1. The Current State of the US Economy
    2. Tighter Financing Conditions and Credit Impulse
    3. The Impact of Credit on the Real Economy
    4. The Role of Bank Reserves and Credit Creation
    5. Real Economy Money Printing and Fiscal Deficits
    6. The Mechanics of Money Printing and Credit Creation
    7. Credit Creation and Bank Lending
    8. The Relationship Between Credit and Stock Market Performance
    9. Insights and Investment Considerations
    10. Investment Outlook and Market Dynamics
    Summary
    Transcript

    The Current State of the US Economy

    00:05 - 07:49

    • The first six months of 2020 have not seen a recession, contrary to expectations.
    • The US economy is currently experiencing below-trend growth at around 1% annualized.
    • The time lags between monetary policy tightening and its impact on the economy are playing out in line with historical standards.
    • The yield curve has been inverted for 13 months, indicating potential recessionary forces in the near future.
    • Inflation and high oil prices caused a slowdown in the economy last year, but since then there has been a reversal and a mid-cycle slowdown.
    • The credit channel is an important factor in how monetary tightening affects the real economy.
    • However, due to a credit bonanza in recent years, households and corporates have locked in long-term funding at low rates, delaying the need for refinancing and potentially prolonging the lags between tightening and economic weakness.
    • Going forward, it is more likely that these lags could kick in as we are now past the period of easy wins from longer lags.
    • Keeping monetary policy tight while economic growth slows down can increase the risk of a complete stoppage of growth. Investors should keep this in mind.

    Tighter Financing Conditions and Credit Impulse

    07:20 - 14:30

    • Keeping rates tighter for longer exerts a net tightening pressure on the economy.
    • Length of financing for corporates is important to consider.
    • Investors should be aware of the maturity wall and potential refinancing needs.
    • Private sector agents will gradually be forced to accept tighter financing conditions.
    • Tighter conditions will impact a broader proportion of the private sector over time.
    • Credit creation in the US has slowed down, affecting both mortgages and corporate borrowing rates.
    • Appetite for credit from the private sector is lower due to higher borrowing rates.

    The Impact of Credit on the Real Economy

    14:06 - 21:25

    • The problem is lags in credit and how long it takes to impact the real economy.
    • Assuming that credit doesn't matter is a potential mistake.
    • Stock market euphoria should not be confused with monetary policy and the functioning of the economy.
    • The price of credit has objectively increased, and the availability of credit has decreased.
    • Only looking at bank lending can be misleading as late-cycle lending tends to be robust due to high loan yields and positive late-cycle fundamentals.
    • Credit flows to the private sector through capital markets or shadow banking should also be considered.
    • The credit impulse in 2022 started declining aggressively and reached low levels by Q1 2023, but there are signs of stabilization in Q2 2023.
    • In 2021, fiscal transfers injected money into the private sector, boosting bank accounts and increasing spendable money.
    • Monetary factors also contributed to rapid money growth for corporates and households.
    • The credit impulse increase in late-2020 was followed by a year-on-year increase in earnings per share in 2021, but it started dropping in late-2021/early-2022.
    • The length of the current cycle's lag may be longer due to the massive credit boom of 2020-2021.

    The Role of Bank Reserves and Credit Creation

    21:07 - 28:27

    • Central banks print bank reserves, not money for the private sector.
    • Quantitative easing involves central banks buying securities from banks, which leads to a lack of collateral for investment funds.
    • Bank reserves accumulate in the banking system while bonds are taken away from pension funds and asset managers.
    • Bank reserves and financial bank deposits do not create real economy money.
    • Low volatility and the abundance of bank reserves can lead to companies, banks, and pension funds being more aggressive in rebalancing their portfolios towards credit.
    • The decision of a corporate to issue more credit is what increases the money in the system, not the action of a bank or pension fund buying the bond.
    • The Bank of Japan's increase in bank reserves did not increase real economy money in circulation.

    Real Economy Money Printing and Fiscal Deficits

    27:57 - 35:24

    • Bank of Japan printed a lot of bank reserves in the 90s and 2000s, but it didn't increase real economy money in circulation.
    • Real economy money creation happens when the private sector decides to lever up and access credit.
    • Bank reserves can be used by banks to rebalance their portfolios or by pension funds to rebalance their portfolios.
    • Real economy money printing only happens through fiscal deficits that increase disposable income without taxing it.
    • Europe's underperformance in GDP and inflation can be attributed to austerity programs from 2012 to 2020.
    • Fiscal deficits not offset by an increase in the treasury general account do not result in increased spending or borrowing.
    • The Federal Reserve can monetize debt by buying treasuries from JP Morgan.
    • Government deficit spending increases bank deposits, which become additional liabilities for banks and are held as reserves at the Fed.

    The Mechanics of Money Printing and Credit Creation

    35:00 - 42:32

    • A bank now has more bank deposits is a jack that has more money
    • The government has to issue bonds to fund the fiscal deficits
    • The government can't blow a hole in their balance sheet accounting wise, so they have to borrow the money and issue bonds
    • Bank deposits end up at a bank, resulting in more bank reserves
    • Primary dealers use reserves to buy bonds issued by the government
    • Fiscal deficits increase bank deposits and bank reserves without decreasing existing reserves
    • Banks don't need to use existing reserves to buy bonds during quantitative easing
    • Real economy money printing happens through fiscal deficits, not quantitative easing
    • The second way to print money is through bank lending
    • Banks credit accounts and create new loans for borrowers like Jack
    • Bank deposits from selling assets always stay within the banking system
    • Banks find new funding through markets like the secured repo market or FED facilities

    Credit Creation and Bank Lending

    42:04 - 49:29

    • Reserves are assets for a bank, not liabilities.
    • Bank lending is the activity of banks making loans and extending credit to the private sector.
    • Credit creation does not rely on existing deposits or the amount of reserves in the system.
    • Banks unilaterally create new money when they make loans.
    • The mechanics of credit creation may differ for a single bank compared to the entire banking system.
    • A single bank needs to find deposits to match new assets created through loans.
    • Some banks have high deposit flight risks and need alternative funding sources.
    • The Federal Reserve provides facilities for banks to access funding, but it can be more expensive than traditional deposits.
    • Bank lending at a system level is real economy money printing.
    • Credit creation can also occur through non-banks, such as capital markets and shadow banking.
    • Structural growth has declined in many economies due to demographics and low productivity rates.
    • Access to credit has allowed the private sector to generate stronger cyclical growth despite low structural growth rates.
    • Total credit to the economy as a percentage of GDP has increased over the last 30 years.

    The Relationship Between Credit and Stock Market Performance

    49:08 - 56:29

    • Total credit to the economy has grown over the last 30 years to replace dwindling structural growth with cyclical growth.
    • The commonly held belief that high interest rates and quantitative tightening are bad for stocks is challenged by the fact that stocks have been outperforming bonds during quantitative tightening.
    • Historical examples show that stock markets performed well in periods of both high and low interest rates.
    • Using one variable, such as net liquidity or real rates, to forecast future stock market returns is unreliable.
    • Net liquidity, often measured using bank reserves, explains only a small percentage (3-10%) of the variability in S&P 500 returns.
    • A multivariable approach is necessary when evaluating macro models and making investment decisions.
    • Changes in bank reserves can explain about 20% of changes in earnings and around 15% of changes in the S&P 500.

    Insights and Investment Considerations

    56:08 - 1:03:09

    • Running macro models for systematic macro investment requires considering multiple variables.
    • Changes in bank reserves do not correlate well with changes in S&P 500 returns.
    • Banks do not use reserves to buy stocks; they primarily invest in Treasuries, corporate bonds, and mortgage-backed securities.
    • Portfolio rebalancing may have a marginal effect on stock prices, but it is not significant enough to cause a decline.
    • Interest rates impact the valuation of the S&P 500; higher rates justify lower multiples.
    • Inflationary trends and low but predictable growth create a goldilocks environment for certain assets.
    • Growth stocks perform well in this environment due to their equity beta and predictable growth.
    • Bonds should also perform well during periods of low inflation and weak growth.
    • Quantitative tightening (QT) by the Fed does not necessarily derail bond performance as other factors like growth surprises and market expectations play a role.
    • Bond yields remain high due to increasing real yields caused by the Fed's monetary policy adjustments.
    • Stocks have outperformed bonds due to the re-rating of growth and multiple expansions.

    Investment Outlook and Market Dynamics

    1:02:49 - 1:09:51

    • The combination of a strong stock market and a stable bond market is due to the re-rating of growth.
    • Investors are optimistic about double-digit earnings per share growth in 2024.
    • Bonds can be a good addition to portfolios as they provide protection against credit events and disinflationary trends.
    • Shorting optionality can be risky, as it only takes one wrong move to suffer significant losses.
    • The cost of buying calls for credit events or recessions is currently low, indicating confidence in the market's stability.
    • Many cuts have been priced out, making it a better trade with improved pricing for 2024.
    • The timing of a recession is uncertain, but it could occur early next year or at the end of this year.
    • Bonds rarely outperform equities, but on a volatility-adjusted basis, there may be an opportunity for bonds to outperform over the next six months.
    • Markets will anticipate a recession before it officially happens, and there is always the possibility of a credit event influencing market dynamics.
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