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Quarterly Review and Outlook

Third Quarter 2018

The U.S. economy appears to be on a World Dollar Liquidity

steadily declining path to recession and disinflation/ annual average of year over year growth rates
30% 30%
deflation. This may seem improbable in the face MB
29.5%
World dollar liquidity (WDL) = Monetary base
(MB) + Foreign official assets held at federal

of record year-over-year growth in nominal GDP

reserve banks: Treasury securities (FH)
25% 25%
WDL

over the past decade (Chart 1). Additionally, the 20%

20.8%
20%
U.S. has experienced record stock prices, record FH
14.9% FH
15% 14.2% 15%
confidence levels, a steady upward march of
coincident economic indicators and the lowest 10% WDL
8.2%
MB
10%
6.3%
unemployment rate (3.7%) reported in the past 49 5% 5%

years. These statistical measures, along with many

FH
WDL MB .8%
-.1% -.8%
0% 0%
others, however, carry no weight regarding future
economic activity. Monetary policy has played a -5%
1960-2008 2009-2014 2015-2018
-5%

major role in determining recessions. But, unlike Source: Federal Reserve. Through August 2018.
Chart 2
the past, the government's debt level has reached
such extreme heights that, like monetary policy, it rates and a 30%, or nearly $1 trillion, reduction
is also serving to restrain economic growth going in excess reserves of the banking system appears
forward. An analysis of these factors leads to the to have had little impact on U.S. growth, as of
inescapable conclusion that a bumpy landing is in yet. True, the interest sensitive sectors – autos
store for the U.S. economy. and housing – have ceased expanding and are
currently a slight drag on overall output, but overall
Monetary Policy consumption, which represents about 70% of GDP,
has remained relatively steady.
Eight policy interest rate increases in short
With lags, the impact of Fed policy,
Nominal GDP however, has a broad reach. As noted in past
year over year % change, quarterly
quarterly letters, Fed policy determines world
6% 6%
dollar liquidity. That liquidity is palpably shrinking
around the world where debt productivity is
4% 4%
considerably lower than in the U.S. As such, the
2% 2%
erosion of dollar liquidity should weaken foreign
economies before the monetary restraint is visible
0% 0% domestically (Chart 2). The symptoms can be seen
in emerging markets with declining equity prices
-2% -2% and in locations where the cheap money policy of
the past has encouraged dollar borrowing. These
-4% -4%
'07 '10 '13 '16 markets are now facing rising interest costs and a
Source: Bureau of Economic Analysis. Through Q2 2018. more expensive dollar, making repayment difficult.
Chart 1

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 Quarterly Review and Outlook Third Quarter 2018

Euro Area and Japan: M2 Bank Loans plus Nonfinancial Commercial Paper
year over year percent change, monthly 3 and 6 month % change, a.r. and
10%
Japan:
5% y-o-y % change
right scale 25% 25%
8% 4% 20% 20%

15% 15%

6% 3% 10% 10%
y-o-y
5% 6 mo 5%
3 mo

4% 2% 0% 0%

-5% -5%

2% 1% -10% -10%

-15% -15%
Euro Area:
0%
left scale 0%
-20% -20%
'07 '08 '09 '10 '11 '12 '13 '14 '15 '16 '17 '18 '19
'09 '10 '11 '12 '13 '14 '15 '16 '17 '18
Source: European Central Bank, Bank of Japan. Through August 2018. Source: Federal Reserve Board. Through 3rd week in September 2018.

Chart 3.a Chart 4

Significantly, U.S. monetary restraint has caused a have dropped to a 2.5% three-month annualized
similar slowdown in local currency money growth growth rate (Chart 4), and the asset growth of banks
around the world (Charts 3.a, 3.b). Additionally, has ceased to expand this year. Another symptom
velocity in Japan, the Euro area and China has been of monetary change, the term spread which is
declining secularly since the late 1990s, as debt has derived from the yield curve, is now clearly re-
become increasingly less productive. Since money enforcing the restrictiveness of Fed policy.
times velocity (i.e. its turnover) determines GDP
in all countries, this cumulative global economic Yield Curve
slowdown should impact U.S. economic activity.
A great deal of analysis has been done
In the U.S., monetary actions have already on this subject. Recently, San Francisco Fed
begun to impact the critical indicators, such as the economists conducted a study on various spreads
money and credit aggregates, while simultaneously in the treasury market. Using monthly data from
lowering the term spread and reducing the January 1972 through July 2018, they looked at
profitability of banks and others who borrow short each spread and predicted whether the economy
and lend long. The annual growth rate in money would be in recession 12 months in the future. The
supply (M2) has slowed to 4%, well below the study found that the ten year-three month (10y-
6.6% annual rate of expansion since 1900. Loans 3m) spread was the “most reliable predictor” in
and leases funded by banks and commercial paper signaling a recession. One of their conclusions,
China: M2 however, was that while the risk of recession might
30%
year over year percent change, monthly
30%
be rising, the flattening of the 10y-3m yield spread
does not currently signal an impending recession.
25% 25%
They also correctly pointed out no causality. The
spread at the time of the article was +100 basis
20% 20% points (bps), or 1%. As recently as late August, the
spread was down to the low 70s, but, quite volatile,
15% 15% it has recently reversed higher.

10% 10%
An examination of this spread since 1953 is
quite revealing (Chart 5). There is the presumption
5% 5%
'09 '11 '13 '15 '17 that it is necessary for the curve to invert prior to
Source: People’s Bank of China. Through August 2018.
recessions, primarily because all inversions have
Chart 3.b

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Term Spread
(10 Year Note Yield less 3 Month Bill Yield)
monthly
5%
4%
3%
2%
1%
0%
-1%
-2%
-3%
1953 1961 1969 1977 1985 1993
Source: Federal Reserve Board. Through September 2018.
been followed by recessions. As this chart reveals,
if this yield spread is still positive but falls below
+40 bps, there is a more than reasonable possibility
of a decline in economic activity. The spread is
quite variable, but at +73 bps, which it was in
August, is close to the +40 bps level which would
signal an outright recession. Two more 25 bps hikes
in the Federal Reserve target rate may be sufficient
to move it to a full recession signal.
This flattening of the term spread, is
consistent with monetary theory. There is a
supportive connection between the flattening of
the term spread and the Federal Reserve action
of reducing total reserves in the banking system.
Thus, it is the Fed reduction in reserves that causes
major flattenings to occur; the movement of the
curve is a symptom of a restrictive monetary
policy. This reserve action is, as mentioned, also
consistent with slow money and credit growth.
The Fed, not surprisingly, acknowledges the curve
flattening, but says it is “one of many indicators”
(true but hardly a comfort). In 1989 and 1999,
the Greenspan Fed said the curve inversion was
not relevant and the economic outlook remained
strong. This may have been one of the main reasons
the Fed did not see the 1990-91 and 2000-01
recessions until they were long underway. The
Bernanke Fed also explained away the yield curve
inversion prior to the collapse of Lehman Brothers
at the start of the 2008 recession.
In addition to signaling the effectiveness of
©2018 Hoisington Investment Management Co. (please see legal information and disclosures on last page)
Quarterly Review and Outlook Third Quarter 2018
a restrictive monetary policy, the flatter term spread
significantly impacts all depository and other
5% financial institutions that are borrowing short and
4% lending long, as their profitability is eroded. When
3% the major costs (net interest margins, overhead
2% costs and the risk premium, or costs associated
1%
with the possibility of a borrower default) are
0%
considered, the easiest option is to reset the risk
premium for loans. This plus increased competition
-1%
typically leads to credit mistakes, even though late
-2%
cycle ebullient business conditions seem to justify
2001 2009 2017
-3%
the lower risk premium. Such holding of risky
assets has not ended well for lenders or investors
Chart 5
in both pre and post-World War II business cycles.
Fiscal Policy
Just as monetary policy is directed toward
slowing growth, fiscal policy is similarly aligned.
Large budget deficits can be associated with
strong growth and higher inflation. Present
circumstances, however, preclude that eventuality
as the prodigious level of government debt had
accumulated to 106.4% of GDP, or $21.516
trillion, at the end of the 2018 fiscal year. Academic
studies have centered around the proposition that
government debt roughly in excess of 90% of GDP
for a period of five years slows economic growth.
Already at 106% of GDP and having been above
90% GDP since 2010, it is understandable and easy
to conclude that past and current fiscal policy will
be contractionary from this point over the long run.
This past year, the enormous increase in debt added
to economic growth, however, this also added to
the already onerous debt burden, meaning it will
act as a drag on future economic growth.
In just the past 12 months, the amount of
federal debt expanded by $1.271 trillion. This is not
to be confused with the increase in the deficit which
totaled only $804 billion. Over the past five years,
the deficit is up by $2.977 trillion, whereas the total
government debt has risen by $4.777 trillion, a
difference of $1.80 trillion. How does this happen?
Simple. Elected representatives have decided that
certain sums of money that are spent (therefore
Page 3
 Quarterly Review and Outlook Third Quarter 2018

paid by borrowed funds) are in fact “investments” Long-Term Government Bond Yields Starting with
rather than “expenses”. These items include certain Historic Panic Years: Japan 1989, U.S. 1873 and 1929
transportation expenditures, federal loan programs, 7%
annual average
7%
U.S. panic year 1873 = year 1
social security/military/civil service payments U.S. panic year 1929 = year 1
Japan panic year 1989 = year 1

where benefits are in excess of tax collections, and 6% Japan 1989 6%

a host of other items. It is material. Over the next 5% 5%

U.S. 2008
five years, the Congressional Budget Office (CBO)
4% 4%
projects the deficit will expand by $5.661 trillion. If U.S. 1873

federal debt continues to rise in excess of the deficit

U.S. 1929
3% 3%

by the same amount as the past five years, then total 2% 2%

debt outstanding will reach $28.9 trillion in 2023,
compared with the CBO's projected GDP estimate 1%
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26
1%

for that year of $24.6 trillion. Debt therefore will Sources: Federal Reserve Board, Homer & Sylla. Bank of Japan. (U.S. through 2017)
Chart 7
reach 117% of a total year’s income / output of the
U.S. economy in just five short years. total saving available for investment (Chart 6).
Since 1929, net national saving has averaged 6.4%,
An analysis of the interconnectedness of but with increasing government deficits (dissaving)
the economy, or what is referred to as the circular over the past 17 years, the national saving rate
flow of the macro economy, reveals another factor, has dropped by more than half to about 3%. It is
over and above the government debt problem, that important to note that the projected increase in
will enhance the impetus for economic activity federal debt from $21.4 to $28.9 trillion will, all
to slow. For all economies, what is produced other things being equal, further reduce net national
equals what is spent, which in turn equals what is saving from approximately 3% to 2% or possibly
earned (i.e., GDP equals Income). Based on this even zero. Thus, investment would be forced
circular flow proposition, algebraically, national downward, continuing to erode productivity,
saving must equal physical investment (S = I). unless, of course, consumer saving were to rise.
Investment is critical to the growth of productivity. But, if consumer saving were to rise, this would
Productivity plus labor force growth determines reduce consumer spending and economic growth,
potential economic growth rates. Therefore, to undermining the incentive for more investment.
get an investment boom, greater national saving is This is a recipe for semi-recessionary economic
required. Herein stands the problem. Government conditions, regardless of monetary mistakes.
deficits are not saving, but dissaving, reducing the Indeed, both fiscal and monetary policy are guiding
U.S. economic growth slower.
Net National Saving by Sector as a % of
Gross National Income The response by policy makers to this
annual
18% 18% eventuality is a guess, but a higher interest rate
16% 16%
14% 14% policy does not appear to be an option. From the
12%
10%
12%
10% standpoint of an investment firm that started in
8%
6%
Average (net) = 6.4% 8%
6%
1980, when 30-year bond yields were close to
Net national
4% Private 4% 15%, the current 30-year treasury rate at 3% seems
2% 2%
0% 0% ridiculously low. In the near future, at 1.5%, the
-2% -2%
-4% -4% 3% yield will seem generous (Chart 7).
-6% -6%
-8% -8%
-10% -10%
-12% Government -12%
-14%
1929 1939 1949 1959 1969 1979 1989 1999 2009
-14%
Van R. Hoisington
Sources: Bureau of Economic Analysis. Through 2017. Lacy H. Hunt, Ph.D.
Chart 6

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 Quarterly Review and Outlook Third Quarter 2018

Legal information and disclosures

Hoisington Investment Management Company (HIMCO) is a Texas-based investment advisor registered with the Securities and Exchange Commission under the Investment Advisers
Act of 1940, in addition to being registered with the Ontario Securities Commission. HIMCO is not registered as an investment adviser in any other jurisdictions and is not soliciting
investors outside the U.S.

HIMCO specializes in the management of fixed income portfolios and is not affiliated with any parent organization. The Macroeconomic Fixed Income strategy invests only in U.S.
Treasury securities, typically investing in the long-dated securities during a multi-year falling inflationary environment and investing in the short-dated securities during a multi-year
rising inflationary environment.

Information herein has been obtained from sources believed to be reliable, but HIMCO does not warrant its completeness or accuracy; opinion and estimates constitute our judgment
as of this date and are subject to change without notice. This memorandum expresses the views of the authors as of the date indicated and such views are subject to change without
notice. HIMCO has no duty or obligation to update the information contained herein.

This material is for informational purposes only and should not be used for any other purpose. Certain information contained herein concerning economic data is based on or derived
from information provided by independent third-party sources. Charts and graphs provided herein are for illustrative purposes only.

This memorandum, including the information contained herein, may not be copied, reproduced, republished, or posted in whole or in part, in any form without the prior written
consent of HIMCO.

©2018 Hoisington Investment Management Co. Page 5