WEEK OF JANUARY 22, 2019 Weekly Relative Value

Too Much Debt

“Debt has exploded during a growing economy… but are we really growing or is it just because we increased the national debt?” – Jeffrey Gundlach, Chief Investment Officer of Double Line Capital (aka “The Bond King”) Tom Slefinger is Senior Vice President, Director of Institutional Fixed Income Sales at Balance Sheet Solutions. One cannot deny that we are now in the throes of a synchronized global slowdown, led by

“The Big Four” – U.S. China, Japan and Germany.

Slowing…

THIS WEEK… • Too Much Debt • $22 Trillion and Rising Fast • China: Leveraged to the Hilt • The Return of Deflation • Drops and Pops • Recession Coming?

PORTFOLIO STRATEGY

Source: HedgeEye Risk Management

In the U.S., real final sales growth throttled back to a 1% stall-speed in the third quarter. Vehicle sales peaked over a year ago and have declined irregularly since then. Meanwhile, the layoffs announced by auto manufacturers are tacit confirmation of faltering sales.

New and existing home sales have fallen 23% and 7% from their recent peaks, respectively. Home prices slowed in December as sales slumped, marking the smallest annual increase since 2012 – the end of the last housing crash when the housing market was just beginning to climb out of the hole left by the collapse. Home builders have expressed concerns over the considerable weakness.

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Capex is nowhere to be seen. Growth slowed again in the third quarter and most of the leading indicators show little in the way of any forward . To wit, the Duke CFO Global Business Outlook Survey revealed that expected capital spending growth in the coming 12 months has gone from 11.0% in the first quarter of last year, to 8.3% in the second quarter, to 5.7% in the third quarter and is now down to a mere 1.0% as of the fourth quarter — the lowest since the third quarter of 2016.

The occurrence of such a significant shift makes an important statement regarding the major corporate tax cut in 2018 and the ability of firms to repatriate overseas funds at low tax rates. These fiscal actions were widely anticipated to lead to a capital spending boom, which has failed to materialize.

CEO Confidence Plummets

Meanwhile, the New York Fed recently updated its recession-risk model for the coming year; it is now up to a 21.4% chance, the highest since August 2008. As a matter of fact, it is precisely where it was in March 2001 — the date that a recession began! And this level accurately foreshadowed the 1990-91 recession by six months.

That said, the New York Fed’s model isn’t perfect. There were two head fakes: the 1995 Mexican and Orange County fiascos and the 1998 Asian/LTCM crisis. They turned out to be “head fakes” because the Fed aggressively cut rates. Intermeeting too. And let’s face it, Fed Chair may be talking less hawkishly, but he isn’t likely to ease policy just yet. (Remember, he tightened into a meltdown in December.)

Back to the graph. You can see that this index does not go to 100%. Generally, the index gets the recession call right in 30%-40% of the time. So, on a “normalized” basis, these recession probabilities are really now between a flip of a coin and two out three.

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New York Fed Probability of a Recession 12 Months Ahead

Source: Bloomberg

Meanwhile in China, retail sales growth has weakened to a 15-year low. In December, auto sales in China plunged 13%, fourth months in a row of double-digit year-over-year declines. Auto sales for the whole year fell 4.1%, the first annual decline in 28 years! Industrial activity has contracted for the first time in 18 months. Corporate profits are in contraction mode. China’s exports for December were far worse than expected as the trade war bites, falling -4.4% from year-ago levels (consensus was +2.0% so quite the “miss”). In a sign of fledgling domestic demand, imports contracted -7.6% (again, the consensus was close but missed the “sign” as it was expecting a +4.5% result). Both readings were the softest in about two years.

The Slowdown in China

Source: Bloomberg

Japan already printed a negative GDP for the third quarter. A clear sign that the Chinese slowdown is spreading.

Ditto for Germany. If it managed to escape a technical recession in the fourth quarter, it was by a hair and no more. Manufacturing activity is in reverse in a major way. And don’t forget that the country is a juggernaut, accounting for about one-third of all output in the euro area. It caters to Chinese demand likely nobody else — and it has to be emphasized that China commands the biggest automotive sector on the planet. To be sure, recent German economic data have been disastrous and confirmed the sharp slowdown in the economy. It will be up to first quarter data to confirm or deny whether a German recession has arrived.

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In its second growth downgrade in three months, the International Monetary Fund (IMF) just slashed its forecast for 2019 global GDP to just 3.5% from 3.7% as of October (its lowest forecast in three years) while warning that trade tensions pose further downside risks to global growth. While its U.S. GDP forecast remained somewhat surprisingly unchanged, still seeing a solid 2.5% in 2019 GDP growth, the IMF took a machete to its German GDP forecast to only 1.3% this year.

The IMF also said, “A range of triggers beyond escalating trade tensions could spark a further deterioration in risk sentiment with adverse growth implications, especially given the high levels of public and private debt.” These potential triggers include more trade tariffs, a renewed tightening of financial conditions, a “no deal” Brexit and a deeper-than-anticipated slowdown in China.

TOO MUCH DEBT

The biggest constraint on the global economy is excess debt.

According to the just-released quarterly report from the Institute of International Finance, the world is “pushing at the boundaries of comfortably sustainable debt.” Indeed, global debt at $244 trillion is now equivalent to a whopping 318% of GDP. Japan and Greece are the most indebted countries in the world, with debt-to-GDP ratios of 237.6% and 181.8%, respectively. Meanwhile, the U.S. sits in the #8 spot with a 105.2% ratio.

And, discussed below, the impact in terms of what this has meant for the economy is in full display

$22 TRILLION AND RISING FAST

In virtually every weekly missive emanating from my perch, I have warned that the growth of the federal deficit and other liabilities are approaching extremely high and counterproductive levels.

The federal debt is now $22 trillion, and the deficit is exploding and just reached $800 billion. Typically, a strong economy is paired with low deficits (or even surpluses) – both because strong economic performance produces more revenue and because it creates the economic space for deficit reduction. Yet, despite the economy performing at or even above its potential, deficits are widening.

In fact, the deficit has never been this high when the economy was this strong. The past two years are extremely abnormal in that we are running high and rising deficits despite low unemployment, no significant output gap, no recession, and strong economic growth. Imagine what happens to the deficits when we end up in a recession.

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Deficits Should Not be Rising

The national debt grew by 6% of GDP last year, which is shocking. In the first three months of fiscal year 2019, the national debt grew by another 8% of GDP, which is equivalent to every U.S. household taking on another $15,000 of debt.

The non-partisan Committee for Responsible Fiscal Budget (CRFB) released its own 75-year budget outlook, which projected an unsustainable fiscal outlook. Under current law, debt will rise from 78% of GDP in 2018 to 160% by 2050 and nearly 360% by 2093. Under the Alternative Fiscal Scenario, debt will exceed 600% of GDP by 2093.

Further, state pension plans are underfunded by about 50%. And according to the usdebtclock.org, there are $122 trillion of outstanding liabilities, including the national debt, state and local government debt, pension fund liabilities and money owed by Social Security. This is six-times the U.S. GDP. Question: How can a $19 trillion-dollar economy support $122 trillion (and counting) of debt? Answer: It can’t.

One consequence of a rising national debt is that it crowds out productive investment, which, in turn, slows income growth. The upshot is that lower debt can actually boost income growth. Congressional Budget Office (CBO) estimates that if debt were reduced to its historic average of about 41% of GDP by 2048, per-capita GNP (a rough parallel for

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average income) would be about $6,000 (6.5%) higher than under current law. Simply holding debt at current levels would boost income per person by $4,000 per year in 2048.

Maybe the “crowding out effect” is why the deficit-financed tax cuts in the U.S. never did produce the economic results that the advocates were advertising. The effects were half what they were under the Reagan tax reform of the mid- 1980s because back then, the federal debt ratio was less than half what it is today.

Less Debt = More Income

CHINA: LEVERAGED TO THE HILT

As a result of the 2008 financial crisis, China launched a stimulus program of mind-boggling proportions. Beijing compelled local governments and state-owned enterprises to take on massive debt for giant infrastructure projects, huge capacity expansions, and pretty much anything else they could imagine that would put people to work and bolster public confidence. Yes, they built ghost cities. Not coincidentally, China has doubled its debt relative to GDP since the beginning of the century, and the bulk of that was after 2009.

Chinese Debt Doubles in 10 Years

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China’s growth rate is expected to decline from the 6.9% growth seen in 2017 to just reported 6.6% in 2018 to say, 6% in 2019. Here in the U.S., we would celebrate 4% growth. (I think by the end of 2019 we may be wishing for even 2% growth.)

More Debt = Less Growth

An IMF study last year measured China’s “credit intensity” over time.

“In 2007-08, about RMB 6½ trillion of new credit was needed to raise nominal GDP by about RMB 5 trillion per year. In 2015-16, it took more than RMB 20 trillion in new credit for the same nominal GDP growth.” – IMF

In other words, in less than a decade, the amount of debt needed to produce a given impact on GDP more than tripled.

That said, look for the government to respond with even more debt and infrastructure spending to try and stimulate the economy and maintain growth in the 6% range. The problem is, like a medicine to which the body adapts, debt is no longer having the same kind of effect.

The past 10-year economic recovery was built on the creation of yet another credit bubble. And the slowdown in the U.S. and China is hard to solve because both countries have the proverbial debt wall. In the next downturn, slowdown, or whatever you call it, Washington and Beijing may not be able to borrow its way out of the hole. Or if they do, the amounts could be astronomically high.

THE RETURN OF DEFLATION

U.S. import prices plunged 1% month-over-month in December after an even-steeper 1.9% decline the month before. This takes the year-over-year trend from +0.5% to -0.6% in the first such swing into negative terrain since August 2014. The core index (excluding food/fuels) is a mere 50 basis points above zero.

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Import Prices (Year-Over-Year Percent Change)

Source: Bloomberg

Together with the latest Producer Price Index (PPI) data, producer prices fell 0.2% last month instead of dipping 0.1% as was expected. But the real kicker was the 0.1% decline in the core reading (excluding food and energy); it seems safe to say that inflation has peaked at extremely muted levels and are now rolling over. This is incredible when you think of how policymakers did everything in their power to create the conditions for accelerating pricing pressures from years of zero interest rates, endless , fiscal stimulus and tariff hikes. Somewhere along the way, the deflationary forces of competition, aging demographics, rampant technological change and excessive debt begin to take a toll.

From a longer-term perspective, the cycle lows in core inflation are getting lower, while the highs are also peaking out at lower levels. With the inflation cycle broken, and as benign as it was, it stands to reason that the Fed rate-hiking cycle is over (the Fed is still exercising restraint via the balance sheet). The next moves will be cuts, not hikes, and one can reasonably expect in this environment a durable bull market in -dated high-quality bonds.

10-Year Treasury Yields Peak Lower and Lower

Source: Bloomberg

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DROPS AND POPS

Economic data have continued to slow across the globe and the U.S. The government is on week five of a shutdown with no apparent end in sight, shaving off growth per week and plenty of companies have come out and have warned about their outlooks for 2019. Yet have not only rallied, but have done so in a vertical fashion with not even a hint of red.

Earnings Expectations Have Crumbled

Source: Bloomberg

As for the equity recovery this year, we have to put this bounce-back in the context of the worst December since 1931. Think about that for a second — the worst December since the depths of the Great Depression. This not a depression nor is it anything close to 2008/09. It is typical in a bear-market for the S&P 500 to reverse 75% of the peak-to- trough decline.

What Goes Up...

Source: Cagle Cartoons

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Take a look at the table below. In prior equity markets, the equity markets did not drop in a straight line. Rather, they fell then recovered and fell again. In the December sell-off, the market went down too far and too fast in a matter of weeks — it took from October 2007 to July 2008 for that first 20% down leg in the last bear market and from September 2000 to March 2001 in the one before that. This time around it took a fraction of that time.

From my lens, the equity recovery is technical in nature given the eroding economic fundamentals. So, enjoy this traders’ bounce until such time that we retest and likely break below those December 24th lows. It usually happens when the bad things the market has been worrying about become so glaring that they’re in every headline. There is no sense trying to time it, but it is important to realize it’s out there.

Drops and Pops

Source: Northman Trader

RECESSION COMING?

We must recognize that recessions are part of the business cycle. A recession typically involves a multi-month period of weak sales, production, employment and income. They come and they go. They typically last a couple of quarters. It’s obvious to those who read my missives that I have been calling for the U.S. economy to shift from slowdown into a recession in the coming quarters.

I also want to stress this will not be a repeat of the global financial crisis of 2008-09. Today, the financial system is rock solid from a capitalization standpoint. Yet, unquestionably, there are financial stresses (i.e., subprime autos, credit cards, leveraged loans, BBB-rated bonds, high credit) but they lie outside the banking system.

With regard to the U.S. , I believe Fed Chair Jay Powell made the right call to pause now. But that monetary policy hits the economy with lags, and research shows that most of the impact of what’s already been done by the Fed hits home this year. In other words, the damage may already be done.

In my humble assessment, he may have overtightened with his last two rate hikes in September and December. When you tack on the reduction in the Fed’s balance sheet, or what’s commonly known as quantitative tightening, the de facto interest rate increase comes to 300 basis points so far this cycle. This is considerable given that we have the most leveraged economy in modern history (not just in the U.S. but globally).

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If we do manage to avert a recession, the coming year still promises to be a difficult one for the economy in the U.S. and abroad. One has to assume the Fed is now seeing the same thing because some officials are openly talking about possibly making the next policy move a rate cut.

MARKET OUTLOOK AND PORTFOLIO STRATEGY

In December 2007, market pundits and economists were broadcasting that there were no signs of a recession. Real GDP growth for 2008 was +2.2% and recession-odds were at 40%, even though the economic downturn had already started that very month. Strategists were calling for a 10% up-year for the S&P 500. Fast forward. The consensus today is calling for 2.5% real GDP growth for 2019, recession odds are pegged now at 25%, and the equity strategists are at +12% for the S&P 500.

Today’s forecasts by these same pundits should be treated with a massive dose of skepticism. It’s one of those times where it’s best to fade the consensus view — as much as it was 11 years ago.

Going forward, the economy will face past and continuing restraint from monetary actions.

The flatter yield curve means that financial entities that borrow and lend long will find their activities less profitable and will slow activity and thus credit will become more expensive or less readily available. Monetary restraint in the form of Fed balance sheet reduction will tighten financial conditions.

A quasi-recession would lead to such diminished inflation that the U.S. economy could face zero inflation or outright deflation. In such an environment, the real burden of the debt levels would become onerous enough to eventually turn a slowdown into a more persistent and/or deeper economic funk.

Even a quasi-recession would necessitate a significant decrease in the rate. On average, during prior periods of slow growth, the and the inflation rate decreased by 300 basis points and 1.3%, respectively.

Thus, even a mild recession in 2019 would put the Fed in an untenable situation. The Fed will not be able to deliver the same rate cut as historically has been the case since the funds rate would be truncated by the zero bound.

The risk is rising that the U.S. will not only return to zero short rates but, as they have in Japan, might remain there for several years.

Given this view, we continue to advocate that credit unions maintain a risk-appropriate, high-quality ladder investment portfolio. It may be tempting to stay in overnight funds or in the front end given how flat or inverted the yield curve has become. However, the medium/long-term risk is that if/when the Fed reverses policy, credit unions will have missed an opportunity to lock in higher yields and returns. Also, by remaining fully invested, credit unions will minimize the reinvestment rate risk. In other words, while staying in cash may seem like a risk averse strategy, it may in fact be adding risk to the balance sheet and reducing income from a longer-term horizon.

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PREMIER PORTFOLIO

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• Access Documents and Reports Easily access key documents, monthly statements and overall market analyses. • View Portfolio Holdings See current investments online and easily export into a spreadsheet format. • View and Buy Offerings Review a list of available security offerings and highlighted specials – place “buy” orders right from the convenience of your desk, AND… connect directly into the SimpliCD website to make CD purchases. • Quickly View Current Rates Stay in the know – view daily rates in the same location where purchase decisions are made. • Read Daily Commentary & Weekly Relative Value Gain access to educational content that tracks market and economic trends, analyzes key releases and watches ongoing political developments. Understand the impacts of current events on credit unions.

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MORE INFORMATION

For more information about credit union investment strategy, portfolio allocation and security selection, please contact the author at [email protected] or (800) 782-2431, ext. 2753.

Tom Slefinger, Senior Vice President, Director of Institutional Fixed Income Sales, and Registered Representative of ISI, has more than 30 years of fixed income portfolio management experience. He has developed and successfully managed various high profile domestic and global fixed income mutual funds. Tom has extensive expertise in trading and managing virtually all types of domestic and foreign fixed income securities, foreign exchange and derivatives in institutional environments.

At Balance Sheet Solutions, Tom is responsible for developing and managing operations associated with institutional fixed income sales. In addition to providing strategic direction, Tom is heavily involved in analyzing portfolios, developing investment portfolio strategies and identifying appropriate sectors and securities with the goal of optimizing investment portfolio performance at the credit union level.

Information contained herein is prepared by ISI Registered Representatives for general circulation and is distributed for general information only. This information does not consider the specific investment objectives, financial situations or needs of any specific individual or organization that may receive this report. Neither the information nor any opinion expressed constitutes an offer, or an invitation to make an offer, to buy or sell any securities. All opinions, prices, and yields contained herein are subject to change without notice. should understand that statements regarding prospects might not be realized. Please contact Balance Sheet Solutions to discuss your specific situation and objectives.

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