Weekly Relative Value

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WEEK OF SEPTEMBER 27, 2021

Tom Slefinger SVP, Director of

Institutional Fixed Income Sales

The Two Most Important Words

Last week, the Fed issued issued its formal policy statement. As expected, the Fed signaled that the pace of bond-buying may soon be warranted. The two words that mattered most were “may” and “if.” The Fed “may” commence with the taper as early as the next meeting (November 3), “if” the economy plays out as expected. Blah, blah, blah. This is typical Fedspeak. They promised nothing and may well do nothing at the next meeting, either. The only question that matters is whether the economy will allow the Fed to embark on this taper process as planned. It is situational. Nothing is etched in stone. Frankly, the Fed simply does not know. (Have you seen their track record?)

The Fed did lower its improbable GDP growth forecast for 2021 to 5.9% from 7.0%. But here’s the rub: even with the growth downgrade, two quarters of GDP are in the books. Q1 and Q2 were 6.3% and 6.66% respectively. The estimate for Q3 (the Atlanta Fed “Nowcast” model) is 3.66%. Thus, for the economy to reach the Fed’s implicit forecast of 5.9%, GDP in Q4 will have to jump to 7.1%. Think about it. The Fed’s growth assumption for Q4 of 7% has not been seen in 37 years. Let’s say this is a low probability event – call it 1-100. This Q4 implicit forecast would exceed Q2 of this year, which occurred only because of the largest unprcedented fiscal stimulus thrust in history. For next year, the Fed expects the economy to expand 3.8%. This is about double what the average pace was in the last economic cycle. I’m going with the odds and will gladly take the “under” for both of these rosey views.

THIS WEEK • THE “USELESS” DOTS • A CHINESE MINSKY MOMENT? • IS COVID GOOD FOR YOUR

WEALTH? • A CANARD PORTFOLIO STRATEGY

“’If’ progress continues broadly as expected the Committee judges that a moderation in the pace of asset purchases ‘may’ soon be warranted.”

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The Fed reiterated that inflation was “transitory.” Which it is. There is no doubt that core personal consumption expenditures (PCE), has steadily increased from 1.8% a year ago to currently 3.6%. However, after stripping out the automotive area, the core inflation rate is around 2%. Unless Powell and the Federal Open Market Committee (FOMC) learns how to build cars with no semiconductors, this is not a Fed issue to resolve. The type of inflation that the world is confronted with, part and parcel of the virus, is not the sort of inflation the Fed is equipped to deal with. THE “USELESS” DOTS The vote for no hikes this year was a unanimous 18-0 score by the FOMC participants. After that it gets interesting. All 18 Fed officials are evenly split on a rate hike next year, which hiked the median plot to a half-rate-hike by the end of 2022. Of the 18 FOMC members, nine believe that we will start to see the first moves occur in 2022, and three of these are penning in two increases. With regards to the funds rate, the median forecast is for the Fed funds rate to be 1% at the end of 2023, but very interestingly, only 1.8% at the end of 2024. So either some Fed policy makers are anticipating a pause in the rate hike cycle, or maybe they have in fact lowered their estimate for the so-called terminal rate – the end-point of the rate hike cycle.

In 2024, one participant thinks the Fed will have short-term rates at 2.50-2.75%. What a hoot! The national debt is over $28 trillion and rising fast. By 2025, as shown below, it could well be close to $50 trillion. At 2.75%, annual interest on the national debt would be almost $1.3 trillion. I believe the participant who thinks the Fed funds rate will only be 0.5-0.75% will be closer to the mark.

Source: www.usdebtclock.org

But here’s the thing about dots: based on previous dot projections, the dots are not important. They are actually useless. Simply put, in the past, the “dots” have been a horrible predictor of the trajectory of interest rates.

Fade this Silliness

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Let’s review some “dot” history: The dot plot was first introduced on January 25, 2012. At that time, the median “dot” implied a year-end funds rate of 0.25% in 2012, 0.25% in 2013 and 0.75% in 2014. The funds rate stayed at 0.25% in all three years. Coming out of the March 2016 meeting, the dot plot was forecasting a funds rate of 0.625% at the end of that year, 1.875% in 2016 and 3.125% by the end of 2017. In reality, the funds rate finished 2015 at 0.375%, was 0.625% by end of 2016 and was 1.375% by end of 2017.

At the September 2018 meeting, the median dot was projecting a funds rate of 2.375% at the end of that year, 3.125% by end of 2019 and 2.375% in 2020. What actually happened was the 2.375% was correct for 2018, but the funds rate was cut to 1.625% in 2019 and 0.125% at the end of 2020. Despite the uselessness of these “dots,” I cannot believe how many market pundits are focused on whether and how the “dot plots” from the Fed will “validate” the consensus view of higher rates sooner, rather than later. My view is to fade the consensus. A CHINESE MINSKY MOMENT?

2016 Dots 2021 Dots

A “Minsky moment,” is the point at which excess debt sparks a financial crisis. The late Hyman Minsky said that such moments arise naturally when a long period of stability and complacency eventually leads to the buildup of excess

debt and overleveraging.

You wonder why I’m a Cynic?

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Evergrande is the world's most indebted developer, with at least $300 billion in debt outstanding. As of today, it is in default. In recent months, a liquidation panic of the company's bonds sent its 2023 bonds from 90 cents on the dollar in June to 26 cents present day. In recent weeks, the collapse has spooked markets, including global equities, credit, FX and commodities. Unlike Lehman, which caused an international implosion of the financial system, most of Evergrande's $300 billion in liabilities are held with creditors in mainland China. The odds remain very high that it will default without a Beijing bailout, which President Xi already said is not coming. What happens to the $368 billion debt load for the country’s second largest real estate operator? Chinese authorities appear determined to ensure some form of orderly workout to avoid disaster.

To be clear, this is is a domestic issue. There there is only an estimated $20 billion in offshore obligations. So, this isn’t a “Lehman moment.” Worldwide contagion might not happen this time. However, none of this is a reason for complacency. There is never just one cockroach. While we don’t know the extent, Jim Chanos, one of the world's most well-known short-sellers, believes that the Evergrande crisis is just a symptom of the property-driven growth model coming to an end and could be "far worse" than a "Lehman-type" blowup for China.

Chanos said the consequences of default by Evergrande could unleash a credit crisis in the country. Chanos could be right. After all, Chinese realtor Sinic Holdings crashed 87% in Hong Kong on fears of a slowdown in the Chinese real estate sector. As BCA Research shows, non-financial corporate debt in China is now on an even larger scale than Japanese corporate debt before its economy went into crisis in the 1990s. This graph also draws comparisons with the peak in debt for South Korea and Thailand in the late 1990s, on the eve of the Asian crisis. Government intervention in China has, so far, averted a major crisis, but that has meant that the debt can keep piling up, in a way that must logically slow down growth in the longer term.

"In many ways, you don't have to worry that it's a Lehman-type situation, but in many others, it's far worse because it's symptomatic of the whole economic model and the debt that's behind the economic model… If you try to deflate

this bubble, it is fraught with risks. I don't think they're contagion risks." – Jim Chanos

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Even if the debt repayment challenges are resolved, the real estate sector – almost 30% of the Chinese economy – is set fo a prolonged contraction and with no other offset. Evergrande accounts for 4% of the property market and avoiding default means fire-sale asset liquidation which fuels deflation across the entire sector. Again, this isn’t a global financial problem. This is a global economic problem. China is currently the world’s fastest-growing major economy and accounts for 30% of world GDP. If Evergrande depresses construction and business activity while raising the cost of capital, growth in China could slip to a very low level. China is also a critical supplier to most others. Any lasting drop would affect businesses worldwide and slow global growth down. This could certainly combine with other forces to generate crisis conditions. The communist party may have to figure out new growth drivers or downshift somewhat semi-permanently into a lower level of growth.

Source: Credit Suisse

Before this mess, there was no mistaking the weakening pace of Chinese economic activity. Retail sales and industrial production have slowed notably for the past four months. This is more than a blip. Property sales in August were down 18.7% year-over-year. And last month, heavy truck production and sales levels were down by half! I should add that tourism revenue was down more than 20%.

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Bottom line: A Lehman event should be avoidable. But a big slowdown in broader growth is harder to avert and Evergrande makes a slowdown look even more likely. Depending on how Evergrande is handled, it may be necessary to price in a milder or more severe slowdownin the world’s second-largest economy. That is its greatest significance.

IS COVID GOOD FOR YOUR WEALTH?

The Fed's latest Flow of Funds report released last week showed the latest snapshot of the U.S. "household" sector as of June 30, 2021. In the second quarter of 2021, the net worth of U.S. households soared by another $5.85 trillion rising to a new all time high of $141.7 trillion. As a percentage of disposable net income, it rose from 698% to 786% – the biggest quarterly increase in history! This number is so ridiculous, it is almost 50% higher than the long-term average of 540%. Heck, tongue in cheek, maybe we should have a pandemic every year.

It would be great if this wealth increase was spread across most Americans. Unfortunately, most Americans aren’t benefiting from recent gains in wealth. Undoubtedly, the pandemic has led to opportunities for many to buy a home or invest while pushing up the financial assets of the "top 10%" to record highs.

"Let's start with the Fed and inequality. I don't think there is any greater engine of inequality than the Federal Reserve Bank of the United States the last 11 years… Why are we making money? Because this guy is printing like there is no

tomorrow." – Stan Druckenmiller

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At the same time, the downturn has disproportionately impacted low-income workers, many of whom rent and don’t participate in the stock market. Indeed, the latest data as of Q1 shows that the top 1% accounts for over $41.5 trillion of total household net worth, with the number rising to over $90 trillion for just the top 10%. Meanwhile, the bottom half of the U.S. population has virtually no assets at all.

On a percentage basis, just the top 1% now own a record 32.1% share of total U.S. net worth, or $45.6 trillion. In other words, the richest Americans have never owned a greater share of U.S. household income than they do, largely thanks to the Fed. Meanwhile, the bottom 50% own just 2% of all net worth, or a paltry $2.8 trillion. They do own most of the debt though... a grand total of $31 trillion. And since the bulk of this wealth goes to a fraction of the wealthiest 1%, America's richest become even richer. As shown in the graph below, the average billionaire has seen his/her wealth rise 1,130% since 1990! Over this same period, the median household has seen an increase of only 5.37%. Yes indeed, it is good to be king!

A CANARD According to the pundits, the first global pandemic in over a century created the conditions for the “Roaring Twenties.” Pundits like Ed Yardeni are touting the new “Roaring Twenties.” It really does boggle the mind. There is no comparison between what the economy looks like today versus how it looked in 1920s. The only thing these decades have in common is that we are coming out of a global pandemic. That’s it!

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Take a look at some key comparative economic fundamentals below (see any similarities):

Demographics 1920: The median age of the population was 28. 2020: The median age is 38.

Debt 1920: Government debt/GDP 10% 2020: Government debt/GDP 110%

Taxes 1920: Personal and corporate tax cuts. 2020: Personal and corporate tax hikes.

Global Trade 1920: Global trade did not exist (Europe was decimated). 2020: Globalization is here to stay.

As we exit the pandemic, all of a sudden, people don’t want to work anymore? They want guaranteed basic income. Retire early and sit on the couch. How will they live? How will they spend? A true mystery. But virtually every pundit is forecasting runaway growth and a return to 1970s inflation (apparently no new semiconductor plant will ever be built again). Excuse my skepticism, but I’ve been in this business for 40 years, have been around the block more than a few times, and I know a canard when I see one. MARKET OUTLOOK AND PORTFOLIO STRATEGY The Chinese economy is sputtering. The U.S. economy is clearly losing steam. The Fed “taper” is a reminder that the central bank is not going to be turning more friendly. The fiscal talks in Congress have hit a snag. The infrastructure tax bill could fail. If it does pass, taxes will need to be hiked. Reading the tea leaves suggests that corporate taxes and capital gains taxes will rise 4% or more, and that income taxes at the highest levels will go back to 39.6% or more, Medicare, etc. And the “debt ceiling” issue is high-drama. Should the Senate not pass a stopgap spending bill by September 30, the U.S. government may shut down. If the U.S. Treasury hits its legal debt ceiling in the next few weeks without an extension, it could have amterail impact on sentiment. That said, this risk is very low and I fully expect the Republicans and Democrats to reach an agreement in the eleventh hour. Even still, it’s a potential fiasco and yet another reminder that Congress is not united. The Treasury market sold off hard last week as the 10-year Treasury yield rose to 1.45% and shattered what had been an effective 1.35% ceiling for the past several months. The technical picture has become challenged and yields could be pressured higher near-term. The yield curve steepened 11 basis points, widening the 2s/10s curve to 118 basis points. Based on the price action, it was as if September payrolls surged above one million! So what happened? The reasons for the changing sentiment were as follows: 1) investors moved to a view that Beijing will ensure a smooth winding down of Evergrande; 2) the markets are of the view that the showdown in Congress is a facade as it pertains to the debt ceiling; 3) the fiscal packages will somehow make their way through Congress; 4) investors like the apparent peaking-out of the Delta variant. Finally, the stock market loved the Fed’s bullish growth forecast (Q4: 7%) while bonds focused on the new dot plots (even though, as discussed above, they are beyond useless) and taper comments. And that is all there is to it.

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What the Fed will end up doing with the taper or future rate hikes will hinge on the evolution of the macro data, and it looks to me as if we are ripe for some hefty growth downgrades from many circles. This tells me that this current bond yield back-up has a very short shelf life. Over the next several quarters, the real risk is a slowdown in consumption (nearly 70% of GDP) due to the end of stimulus, stagnant wage growth and high levels of underemployment. If so, consumption will revert to the mean as stimulus fades from the economy. As the consumer slows, economic growth will be at a new lower trend. Longer term, don’t bank on the Roaring 20s! That’s a fairy tale. Post the “COVID Crisis,” expect the “New New Normal” of lower growth and lower inflation to resume once the dust settles from the COVID pandemic. Remember the last time the Fed tried to normalize rates? They couldn’t raise the funds rate above 2.5% or shrink the balance sheet without the economy rolling over and credit markets freezing up in late 2018. Here’s why. The world is awash with debt. In 2007, we had an unstable situation with global debt at $170 trillion (that is trillion with a T) or 280% of GDP. Today, that debt number is $300 trillion or 350% of GDP! Since the pandemic started, outstanding debt has soared near $40 trillion. You can fit two U.S. economies into that number! So here’s the scoop: Rates can barely go up, no matter what the Fed or other central banks do. The debt burden on this planet is even bigger than greenhouse gas emissions and a chronic source of constraint on economic growth, inflation and interest rates. In terms of portfolio strategy, credit unions (and banks) have experienced deposit growth that has far outpaced loan growth and net interest margin (NIMS) remain under pressure. This pressure on NIMS will likely continue well into 2022. As such, we continue to advocate that credit unions reduce excess cash levels and make quality loans, invest in loan participations, or invest in high quality investments further out the yield curve to enhance yield and income. From a tactical perspective, I say buy the dips on the current Treasury market correction. And as noted above we could see additional weakness in the days ahead. However, any temporary selloffs (such as experienced last week) in the bond market provides an attractive entry point to deploy excess cash. LOAN PARTICIPATION PLATFORM

At Alloya, we have made it our mission to make loan participations simple so you can grow your loan portfolio or free up liquidity with ease. So, if you hear “loan participations” and think “time-consuming hassle,” forget what you know and reimagine loan participations.

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Think fast, easy, and convenient. Think full transparency, trusted service and reliable support. Whether you are a seasoned loan participation professional or new to the process, we are here to help balance your credit union’s loan portfolio through the purchase and sale of loans among the largest credit union network in the industry – all in a matter of a few clicks from the convenience of the internet.

Visit www.alloyacorp.org/participateonline or contact your Alloya representative to learn more and get started.

MORE INFORMATION

For more information about credit union investment strategy, portfolio allocation and security selection, please contact the author at tom.slefinger@alloyacorp.org 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 Alloya Investment Services, 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.

The views and opinions expressed herein are those of the author and do not necessarily reflect the views of Alloya Corporate Federal Credit Union, Alloya Investment Services (a division of Alloya Solutions, LLC), its affiliates, or its employees. The information set forth herein has been obtained or derived from sources believed by the author to be reliable. However, the author does not make any representation or warranty, express or implied, as to the information's accuracy or completeness, nor does the author recommend that the attached information serve as the basis of any investment decision and it has been provided to you solely for informational purposes only and does not constitute an offer or solicitation of an offer, or any advice or recommendation, to purchase any securities or other financial instruments, and may not be construed as such.

Information 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. Investors should understand that statements regarding prospects might not be realized. Please contact Alloya Investment Services* to discuss your specific situation and objectives.

*Alloya Investment Services is division of Alloya Solutions, LLC.