Wasatch-Hoisington U.S. Treasury Fund® (WHOSX) 

Q2 2018
Monetary Indicators Point to Global Slowdown
by Van R. Hoisington, V.R. Hoisington Jr. and David Hoisington

“It is evident that the major policy and structural issues, such as overindebtedness, the reliance on additional debt to provide growth, poor demographics, technological constraints and potential trade conflicts, will continue to weigh heavily against ebullient growth.”

Van Hoisington
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Investing in bonds, you are subject, but not limited to, the same interest rate, inflation and credit risk associated with the underlying bonds owned by the Fund. Return of principal is not guaranteed. Interest rate risk is the risk that a debt security’s value will decline due to changes in market interest rates. The interest rate is the amount charged, expressed as a percentage of principal, by a lender to a borrower for the use of assets. Even though some interest-bearing securities offer a stable stream of income,their prices will fluctuate with changes in interest rates. Inflation risk is the possibility that inflation will reduce the purchasing power of a currency, and subsequently reduce the value of a security or asset, and may result in rising interest rates. Inflation is the overall upward price movement of goods and services in an economy that causes the value of a dollar to decline. Credit risk is the risk that the issuer of a debt security will fail to repay principal and interest on the security when due. Credit risk is affected by the issuer’s credit status, and is generally higher for non-investment grade securities.

For the period ended June 30, 2018, the average annual total returns of the Wasatch-Hoisington U.S. Treasury Fund for the one-, five- and ten-year periods were 0.17%, 5.09%, and 6.92%, and the returns for the Bloomberg Barclays US Aggregate Bond Index were -0.40%, 2.27%, and 3.72%.  Expense ratio: Gross 0.72% / Net 0.72%.

 

Data shows past performance, which is not indicative of future performance. Current performance may be lower or higher than the data quoted. To obtain the most recent month-end performance data available, please click on the “Performance” tab of the individual fund under the “Our Funds” section. The Advisor may absorb certain Fund expenses, without which total return would have been lower. Investment returns and principal value will fluctuate and shares, when redeemed, may be worth more or less than their original cost.

Wasatch Funds will deduct a 2.00% redemption proceeds fee on Fund shares held 60 days or less. Performance data does not reflect the deduction of fees, including sales charges, or the taxes you would pay on fund distributions or the redemption of fund shares. Fees and taxes, if reflected, would reduce the performance quoted. Wasatch does not charge any sales fees. For more complete information including charges, risks and expenses, read the prospectus carefully.

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OVERVIEW

The views expressed in this commentary are those of Hoisington Investment Management Company, the sub-advisor to the Fund, and may differ from the views of Wasatch Advisors.

Details of the Quarter

During the second quarter, a further dramatic flattening of the yield curve continued to define the U.S. Treasury market. On the front end of the yield curve, the yields on Treasury bills and notes (maturities of three years or less) rose, reflecting the Federal Reserve’s increases in the federal-funds rate in March and again in June. As of June 30, 2018 the federal-funds rate was at a range of 1.75% to 2.00%. The long end of the U.S. Treasury bond market (bonds with maturities longer than 20 years) rose at times in response to yield pressures at the front end of the curve and inflation concerns. Long Treasury yields also tended to push higher under indications that real gross domestic product (GDP) growth was accelerating. Oil and gas exploration continued to advance while consumer spending, housing and traditional capital spending (capex) indicators lost momentum and point to considerably weaker growth over the balance of 2018. At the end of the volatile second quarter, the 30-year Treasury bond yield finished at 2.98%, or within one percentage point of the first quarter’s close in 2017.

The flattening yield curve signals that the Fed’s efforts to tighten money and credit availability are currently working. But the changing curve also reduces the profitability of banks and non-bank financial institutions that are borrowing short and lending long because the spread between short-term interest rates and long-term interest rates is narrower. Thus, the flatter curve ultimately reinforces the restraining effects of a major slowdown in the reserve, monetary and credit aggregates.

In the second quarter, the Wasatch-Hoisington U.S. Treasury Fund gained 0.74% while the benchmark Bloomberg Barclays U.S. Aggregate Bond Index declined -0.16%. For the trailing 12 months ended June 30, 2018, the Fund gained 0.17% versus a loss of
-0.40% for the benchmark. At the end of June, the yield on the 30-year U.S. Treasury bond was 2.98%, which was higher than the yield of 2.84% in June 2017. Thus, the increase in yields meant that a slight fall in the prices of the Treasury securities held by the Fund reduced the return less than the coupon earned on those positions. 

Overview: Expectations and Disappointments

Coming out of 2017, expectations were widespread that a synchronized global expansion lay ahead for 2018. Forward momentum was thought to prevail in Europe, Japan and the emerging markets. A doubling of the growth rate in public and private debt in 2017 over the prior year’s rate seemingly pointed to better performance in China, and a sizable tax cut was expected to propel U.S. economic growth upward and contribute to improving global conditions. Business conditions outside the U.S., however, have significantly disappointed investors thus far in 2018. Europe’s growth has abruptly slowed, and Japan’s GDP contracted in the first quarter. China’s growth has slowed as well; China’s GDP growth rates remain at historically low levels, and in May, China experienced the slowest year-over-year growth in retail spending in 15 years. Additionally, numerous problems have arisen in key emerging markets, including Brazil, Argentina, South Africa, Turkey and others. These developments are reflective of a noticeable deceleration in monetary expansion and the debilitating impact of high debt levels.

Synchronized Global Monetary Deceleration

All major central banks of the world—the Federal Reserve (Fed), the European Central Bank (ECB), the Bank of Japan (BOJ) and the People’s Bank of China (PBOC)—are simultaneously presiding over a significant contraction in their respective M2 year-over-year growth rates. M2 is the part of a country’s money supply consisting of currency and checking accounts, consumer-type time and savings accounts and equivalent near monies. The reduction in growth of the U.S. reserve, monetary and credit aggregates, along with a major flattening in the yield curve, has been followed by weaker M2 growth in China, the euro area and Japan. Part of this impact is captured by the concept of world dollar liquidity.

World Dollar Liquidity. The U.S. dollar is still the world’s reserve currency and the Federal Reserve, de facto, its central bank. Under this assumption, economist Rod McKnew developed the concept of world dollar liquidity, which is the sum of the U.S. monetary base and Treasury securities owned by foreign central banks and held at the Federal Reserve Bank of New York. This measure, which was expanding at nearly a 21% growth rate from 2009-2014, has dramatically downshifted its trajectory to essentially no expansion from 2015 to May 2018. Thus, by tightening monetary conditions domestically, the Fed also drained liquidity globally.

Europe. On a year-over-year basis, euro area M2 growth peaked slightly below 7% in mid- to late 2015, less than a year after the end of the Fed’s third and final quantitative easing (QE) program. Since late 2015, M2 growth slowed to 5.2% for the 12 months ended September 2017 and then saw an even sharper decline to 4.4% for the 12 months ended May 2018. This downward shift continued even as the ECB engaged in QE throughout the period. The ECB will continue to pursue QE until the policy terminates in December 2018.

China. In China, year-over-year M2 growth was 13.7% in November 2015, the last month before the current Fed tightening cycle began. In May 2018, the annual M2 growth rate fell sharply to 8.9%, a near record low since 2000. April and May’s historically weak M2 expansion is notable since it appears the PBOC’s reserve requirement cuts failed to reverse the trend.

Japan. The BOJ has been engaged in QE, and interest rates have been negative or near zero. Yet Japan’s M2 growth rate has continued to fall as U.S. monetary restraint intensified. In the 12 months ended in May 2018, M2 increased by just 3.2%. This was a deceleration in growth of nearly 25% from October 2017. Looking back, May’s M2 growth is below the entry point of the 2014 recession. It is not surprising, with the sharp deceleration in money, that Japan’s economy contracted in the first quarter of 2018 by 0.6%.

It appears that the ceasing of growth in world dollar liquidity since 2015 has had a noticeable deleterious impact on the world’s monetary expansion.

Velocity and U.S. Recessions

Money velocity (V) is determined by a complex mathematical function and influenced by long-term, short-term and cyclical factors. Long-term factors are persistent and will prevail over time. Short-term factors, like massive swings in inventory investment, are quick to fade. Cyclical factors may hold sway around economic turning points, particularly when the economy is shifting from expansion to contraction. The complexity should not be surprising since V = GDP / M2 and GDP = C + I + G + X (“C” equals spending by consumers, “I” equals investment by businesses, “G” equals government spending and “X” equals net imports, which is the value of exports minus imports). Anything that influences consumption, investment, government spending or net exports will have some influence on velocity. Thus, Irving Fisher’s equation of exchange (GDP = M2 x V) is only the starting point in assessing fluctuations in velocity.

The dominant secular determinant of velocity appears to be the GDP-generating capacity of debt, which is declining in all major economies world-wide. Money and debt are created simultaneously. If the debt produces a sustaining income stream to repay principal and interest, then velocity will rise, since GDP will eventually increase beyond the initial borrowing. If advancing debt produces increasingly smaller gains in GDP, then V falls. Financing consumption may temporarily boost GDP and velocity over short time spans, but it does not generate new funds to meet longer-term debt servicing obligations. Consistent with this interpretation, velocity has fallen dramatically since 1998 for all four economies: the U.S., Europe, Japan and China.

On a long-term basis, velocity is below historical norms in all four major economic powers. As the productivity of the debt has fallen significantly over the past 20 years, so has velocity. In the more heavily indebted Japan, China and the euro area, velocity is lower than in the less indebted United States. Thus, other than for short non-sustaining episodes, velocity will reinforce, not offset, the decrease in M2 growth evident world-wide.

U.S. velocity is estimated to have risen in the second quarter of 2018 after small quarterly increases since mid-2017. Historically, such increases have occurred when M2’s growth has dropped sharply, as is the case in the current Fed cycle. Both Milton Friedman and Irving Fisher wrote about this cyclical tendency, and Fisher’s equation of exchange is key to understanding such an event. Counting the recessions of the early 1980s as one, there have been 20 contractions since 1900, and M2 growth decelerated prior to 17 of these recessions. With GDP as the ultimate coincident indicator and M2 as the leading indicator then, algebraically, velocity will lag. Consequently, velocity has risen going into the vast majority of these recessions.

The slowdown in money growth, combined with the secular weakness in velocity, indicates that the global aggregate demand curve over time will shift inward, simultaneously weakening inflation and economic growth. Since inflation is a money/price/wage spiral, the longer-term inflation risks are clearly to the downside. Monetary policy operations will restrain future economic growth, and the impact will be surprising due to the long-lagged effects.

Diminishing Returns—Consequences of Excess Debt

Diminishing returns rest upon the production function that states physical output is determined by the inputs or factors of production. When a factor of production, such as capital, initially increases, output rises at an increasing rate. As excess use of that factor continues to advance, the rate of gains in output slow, flatten and eventually turn down, a condition referred to as negative returns. Thus, the relationship between the excess use of a factor of production and the output is nonlinear.

Using this theory that the excess application of an input will lead to diminishing returns, it is possible to see why academic work has concluded that excess application of debt in an economy leads to slower economic growth in a nonlinear fashion. If debt is adjusted for price level changes, then debt is in real or physical terms and thus consistent with the law of diminishing returns. The pattern of unexpected economic weakness in heavily indebted economies has been repeated frequently in Japan, Europe, China and the emerging markets. Japan, the most indebted nation, experienced three additional recessions after the 2008-09 recession. Among the world’s major economic areas, the U.S. economy presently stands out. The disparity in this performance is an unseen consequence from the excess use of debt.

After decades of overuse, debt is increasingly less productive in all of these areas. Ten years ago, the debt overhang was centered in the U.S., the euro area and Japan. Currently, all major economic regions fit this description as China and the emerging markets separately now carry record levels of debt relative to GDP. The Bank for International Settlements shows that in 2017, one dollar of nonfinancial debt generated $0.40, $0.38, $0.39, $0.35 and $0.27 of GDP, respectively, in the U.S., the euro area, China, the United Kingdom and Japan. All of these data points have significantly worsened over the last decade, the greatest deterioration being the debt-to-GDP ratio of China, which has declined by 43% since 2008. Among all regions, Japan’s debt exhibited the weakest level of debt productivity at $0.27. While one dollar of emerging market debt produced a seemingly enviable $0.52 of GDP in 2017, this ratio was down 38% from 2007.

Technology and Diminishing Returns

In addition to capital, output is a function of labor, natural resources and technology. Thus, one of these latter three factors must accelerate in order to offset the overuse of debt if production growth is to accelerate and thus boost the standard of living. Natural resources and labor are unlikely to be of immediate benefit. New discoveries of raw materials have been occurring, but only serve to balance exhaustion of known supplies. Labor is not promising for the near term since the demographics of aging populations in the U.S. and globally remain bleak. Technology is another factor that must not be overlooked. While many dramatic advances are underway, the role of invention in the future trend of U.S. and global growth is more complex than generally understood.

Robert J. Gordon, a distinguished Professor of Economics at Northwestern University and author of The Rise and Fall of American Growth: The U.S. Standard of Living Since the Civil War (2016), considers today’s inventions to be more evolutionary than revolutionary since they do not entail the massive use of labor and natural resources as did inventions of the past. Gordon looked at inventions from the great American economic growth era of 1870 to 1970. The five major inventions—electricity, modern communications, the internal combustion engine, urban sanitation, and pharmaceuticals and chemicals—greatly enhanced the demand for labor and natural resources and resulted in complete economic involvement. Information technology, while life changing in many ways, impacts a narrower economic segment. Furthermore, business productivity from the late 20th century’s digital revolution has stalled these past two decades due to innovation saturation. Viewed from a longer-term perspective, the differential effect of present inventions is already apparent. In his working paper, “Why Has Economic Growth Slowed When Innovation Appears to Be Accelerating?” (National Bureau of Economic Research, NBER Working Paper No. 24554, Issued in April 2018), Gordon calculates that the decline in economic growth in the last decade is a stunning seven times lower than the average growth rate for the 50 years between 1920 and 1970 in real GDP per capita terms.

If Gordon’s view is somewhat overstated, it nevertheless appears that some current technological inventions will tend to depress demand for two other factors of production—labor and natural resources. According to the latest available data from the U.S. Bureau of Labor Statistics, there are approximately 3.5 million people working checkout machines, 1.4 million driving trucks and two million operating machine tools and assembly lines. Using robots to do these functions does not materially change the demand for natural resources but renders obsolete nearly seven million jobs.

Looking Ahead

The second quarter’s growth has reflected a bounce from the first quarter’s noticeable weakness, but a reversion to a more modest expansion will be evident in the latter half of the year since there has been no change in the long-term growth constraints on the U.S. economy. It is evident that the major policy and structural issues, such as overindebtedness, the reliance on additional debt to provide growth, poor demographics, technological constraints and potential trade conflicts, will continue to weigh heavily against ebullient growth.

The long end of the Treasury bond market has, in our view, reflected the harsh realities constraining economic expansion. When the Fed began its current regime of restraint in late 2015, the 30-year Treasury bond yield was around 3%, similar to where it is today. The bond market has been buffeted by numerous transitory factors, with the yield moving above and below this level. Many of these developments entailed market psychology and a potpourri of inconsistent developments that will not impact long-term fundamental economic conditions. While long bond yields can rise as result of a replay of similarly unpredictable events or the current monetary-policy stance, the structurally weak U.S. economy does not support current interest rate levels. The excess levels of debt continue to amass and the short-term beneficial aspects of even higher levels of debt are likely to be increasingly fleeting. Moreover, the growth impediments on the U.S. economy are more serious in many other parts of the world. Importantly, as Friedman rigorously proved, a noticeable period of monetary deceleration, now synchronized globally, is consistent with lower, not higher, interest rates.

As such, we believe the U.S. Treasury Fund’s investments in long-term Treasury bonds is appropriate under these conditions.

Thank you for the opportunity to manage your assets.

Sincerely,

Van Hoisington, V.R. Hoisington, Jr. and David Hoisington

 

 

**The Bloomberg Barclays US Aggregate Bond Index is a broad-based flagship benchmark that measures the investment grade, US dollar denominated, fixed-rate taxable bond market. The index includes Treasuries, government-related and corporate securities, mortgage-backed securities (MBS) (agency fixed-rate and hybrid adjustable-rate mortgage [ARM] pass-throughs), asset-backed securities (ABS) and commercial mortgage-backed securities (CMBS) (agency and non-agency). You cannot invest directly in this or any index.

The Aggregate Demand (AD) curve illustrates the relationship between economic goods demanded and the price level, assuming all else is held constant. Aggregate Demand (AD) is the total amount of goods and services demanded in the economy at a given overall price level and in a given time period. 

A credit aggregate measures the stock of bank loans outstanding at a point in time.

Debt-to-GDP ratio is a measure of a country’s federal debt in relation to its gross domestic product (GDP). The higher the debt-to-GDP ratio, the less likely the country will be to pay back its debt, and the higher its risk of default.

The federal-funds rate is the interest rate at which private depository institutions (mostly banks) lend balances (federal funds) at the Federal Reserve to other depository institutions, usually overnight. It is the interest rate banks charge each other for loans.

The Fisher equation in economics estimates the relationship between nominal and real interest rates under inflation. It is named after Irving Fisher, who was renown for his work on the theory of interest. In economics, this equation is used to predict nominal and real interest rate behavior.

Gross domestic product (GDP) is a basic measure of a country’s economic performance and is the market value of all final goods and services made within the borders of a country in a year.

GDP-per-capita is a measure of the total output of a country that takes the GDP and divides it by the number of people in the country.

A monetary aggregate measures the stock of money outstanding within an economy at a point in time.

M2 money supply consists of currency and checking accounts, consumer-type time and savings accounts and equivalent near monies, while M3 money supply consists of M2 plus business-type time deposits and less liquid near monies. Both M2 and M3 exclude monies and near monies owned by the Treasury, depository institutions and foreign banks and official institutions and IRA and Keogh balances owned by consumers.

Quantitative easing is a government monetary policy used to increase the money supply by buying government securities or other securities from the market. Quantitative easing increases the money supply by flooding financial institutions with capital in an effort to promote increased lending and liquidity.

The reserve aggregates are comprised of the monetary base and all other measures that are components of the monetary base such as total reserves and excess reserves and as such they are components of the Federal Reserve’s balance sheet.

The velocity of money (V) is defined as the rate at which money circulates, changes hands or turns over in an economy.

The yield curve is a line on a graph that plots the interest rates, at a set point in time, of bonds having equal credit quality, but differing maturity dates. The most frequently reported yield curve compares three-month, two-year, five-year and 30-year U.S. Treasury securities. This yield curve is used as a benchmark for other interest rates, such as mortgage rates or bank lending rates. The curve is also used to predict changes in economic output and growth.

Bloomberg Barclays US Aggregate Bond Index covers the U.S. investment grade fixed rate bond market, including government and corporate securities, agency mortgage pass-through securities, and asset-backed securities. To be included in the index the security must meet the following criteria: must have at least one year to final maturity, regardless of call features; must have at least $100 million par amount outstanding; must be rated investment grade or better by Moody’s Investors Service, Standard & Poor's, or Fitch Investor's Service' must be fixed rate, although it can carry a coupon that steps up or changes to a predetermined schedule' must be dollar-denominated and nonconvertible. All corporate and asset-backed securities must be registered with the SEC and must be publicly issued. 

You cannot invest directly in indexes.

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