Posts Tagged ‘David Rosenberg’
Monday, October 22nd, 2012
Earlier this week two former Merrill colleagues, since separated, were reunited on several media occasions, and allowed to spar over their conflicting views of the world. The two people in question, of course, are Gluskin Sheff’s David Rosenberg, best known during the past 3 years for not drinking the propaganda Kool-Aid, and systematically deconstructing every “bullish” macroeconomic datapoint into its far more downbeat constituent parts, and his ebullient ex-coworker, Richard Bernstein, formerly head of equity strategy at a firm that had to be rescued by none other than Bank of America and currently head of RBA advisors, who just happens to be bullish on, well, everything. Rosenberg decided to dedicate his entire letter to clients today to “providing a rebuttal” of the slate of reasons why according to Bernstein the “we are on the precipice of a 1982-2000 style of secular market.” What follows is one of the most comprehensive “white papers” debunking the bullish view we have seen in a while. Read on.
From Gluskin Sheff’s David Rosenberg
R AND B
It is music though not necessarily of the B.B. King variety. It’s the Rosenberg and Bernstein duet.
My good friend and former Merrill Lynch research colleague Richard Bernstein and yours truly duked it out at a business executive forum on Thursday over the market outlook.
It was like the good or days and felt really good.
I would say that over the long haul, Rich and I tend to share very similar philosophies regarding global events and how they will play out over time.
But when we differ, we differ big time.
That said, I have to tip my hat to Rich for having been earlier than I on the bull call for equities this cycle. At the same time, the bond-bullion barbell strategy and S.I.R.P. thematic has also managed to help generate decent risk-adjusted returns over the past three-plus years.
But kudos to Rich for the stock market view. That’s what the debate was (and is) about. He got it more right than wrong. Be that as it may. just as past returns are never a guarantee for future performance in the money management field, so it is true in the realm of forecasting that extrapolating your latest successful calls can often be a big mistake.
Rich has said verbally and in print that we are on the precipice of a 1982-2000 style of secular bull market and has listed a slate of reasons why, and I intend on providing a rebuttal to each.
First, Rich is excited about the fact that the total national debt (government, business and household combined) has come down to 340% from the record peak of 370% set in 2009 and as such the deleveraging phase is gathering apace. I agree that going on a debt diet is a good thing to do, but it also eats into domestic demand and is one of the reasons why this goes down as the weakest economic recovery on record. And at 340% on the aggregate debt/income ratio, we are merely back to the levels we were at the bubble highs five years ago.
I find it doubtful that the debt ratio has managed to find its way back to a sustainable level, and Rogoff and Reinhart did the hard research showing that post-bubble deleveraging cycles last at least ten years. So in baseball parlance, we’re probably no better than in the fourth or fifth inning. And don’t forget that the wonderful 1982-2000 secular bull run was caused in part from the multi-year run-up in the all-in deb/GDP ratio from 160% to 260% — the correlation with the S&P 500 was large at 82%. To be sure, correlation does not imply causation, but there can be little doubt that the proliferation of credit products and ever-greater accessibility to leverage contributed immensely to economic growth and corporate profits during that virtually non-stop two-decade period of unbridled prosperity. Today, and tomorrow, the movie is continuing to run backwards and will prove to be an enduring drag on the pace of economic activity, not just in the USA, but globally.
Three other critical differences worth mentioning before moving on. In 1982. at the start of the secular bull run, the median age of the 78 million pig-in-the-python otherwise known as the baby boomer, the group which controls most of the wealth and has had a big hand in influencing everything in the past six decades from capital markets to the economy to politics, was 25 years old, heading into their prime risk-taking years and as such ushering in the era of aggressive growth and capital appreciation strategies. Today the median age is 55 and going on 56 and the first of the boomers are now turning 65— 10,000 will be doing so each day for the next eighteen years. And their tolerance for risk and need for income is considerably different than it was three decades ago. That much is certain.
The expansion in credit and the favourable demographic trends in that 1982- 2000 period helped generate annual economic growth, in nominal terms, of nearly 6.5% on average, taking the trend in corporate profits along for the ride. Not even the most bullish prognosticators see growth coming in anywhere near that pace for the foreseeable future.
And of course, while Ronald Reagan was no fiscal conservative, his worst sin was a 6% deficit GDP ratio, much of it being cyclical by the way, and a 28% federal debt/GDP ratio. Today the deficit is closer to 8% (there is a much larger structural component) and the federal debt/GDP ratio is about to pierce the 70% threshold. Not to mention entitlements being a much more acute ticking time bomb as the ponzi schemes are that much closer to facing insolvency without some tinkering. Remember — fiscal policy in the U.S. in the go-go 1980s and 1990s was all about receding top marginal tax rates and greater deductions. Everybody liked this so much that many of the folks sitting across the aisle from the GOP were labeled “Reagan Democrats”.
No such bipartisanship exists today, nor is it likely to given the large degree of acrimony, so evident in the last presidential (and veep) debates. It may end up taking some sort of a crisis, in the end, to galvanize the two parties to work towards a resolution to the fiscal morass (as happened in Canada in the early 1990s). That Obama can never seem to get a budget passed or that Simpson-Bowles is collecting dust was not the politics of the Reagan-O’Neill accords of the 1980s. Even Clinton learnt how to compromise and work with the enemy (he was very good, by the way, at the Democrat convention — no doubt he would win another term running against either candidate, and it was so obvious that neither one really fully comprehends just how massive the fiscal problem is and the complexity and painful shared sacrifice that it will take as part of any viable solution).
The 1980s and 1990s were all about industry deregulation. That fostered a durable expansion of both the ‘E’ and the ‘P/E’ as far as equity market valuation was concerned. That is hardly the case today, is it? And the 1980s and 1990s were all about breaking down harriers to global trade, again allowing for greater multiple expansion. This cannot be emphasized enough, especially in lowering business costs. Today, trade tensions are growing and protectionism rearing its ugly head via surreptitious currency wars.
Sorry, but it ain’t the 1980s and 1990s all over again, by any stretch. What the stock market has really experienced is a classic reflexive rebound from a depressed oversold condition, aided and abetted by radical government intervention, not entirely unlike what we saw from 1932 to 1936.
As I said, in 1936, it would have been foolhardy to have overstayed the party by extrapolating a vigorous bounce off the trough into the future. I recommend that people don’t repeat that mistake. The reason why policy rates in most parts of the world are at or near zero percent is because risk is high. Especially political risk. Make sure this is acknowledged in every financial decision you make.
Moreover, in the 1980s and 1990s, the government was getting out of the way. Back then, if a publicly elected official asked “what can I do for you”, the answer by most was “nothing. Thanks”. Today, the same question is met with “where’s my cheque”? In the 1980s and 1990s, the Fed was ushering in an era of disinflation, again a powerful way to expand the market multiple — which it did — as it led to better business decision-making and more efficient resource allocation.
Now the Fed is covertly attempting to create inflation so as to monetize our debt morass. Not only was government getting out of our way in the 1980s and 1990s, but the Federal Reserve found its moorings under the legacy of Paul Volcker, and followed years of what can only be described as a sound money policy. We have on our hands today, not just the Fed but many major central banks manipulating interest rates and relative asset values. It is imperative to recognize that as the Fed and ECB act in a manner today that has investors convinced that “tail risks” are being reduced, the cost of these unconventional policy measures are both unknown but very likely far-reaching, and have thereby introduced “tail risks of their own, even if not realized for years down the road.
Anyone who does not recognize the extent of the Fed’s manipulation in order to generate a positive wealth effect on spending should not be in the wealth management business. Because managing wealth means managing risks… and the Fed and other central banks have merely papered over the debt overhang by printing vast amounts of paper money. Once the inflation does come back, believe me, all hell will break loose, and the law of unintended consequences will rear its head. At that point, the Fed will have no choice but to do some very heavy backtracking and the game will be over. This again is being very forward- looking, to a fault perhaps, but the Fed, once it gets the inflation it so desperately wants, will he slow to respond at first but will end up having to unwind its pregnant balance sheet. One reason why gold bullion and gold mining stocks will prove to have been very effective hedges down the road (but when buying the companies, be very selective).
If you are bullish on equities, at least he bullish for the right reason. For the here and now, the correlation is dominated by the size of the Fed balance sheet. From 2000 to 2007, the correlation between the Fed’s balance sheet and the direction of the S&P 500 was less than 20%. Since 2007, that correlation has swelled more than four-fold to 86%. This is the missing chapter in the classic Graham and Dodd textbook on value investing, published 80 years ago.
So no doubt, Ben Bernanke (as well as Mario Draghi have thought their balance sheet machinations have been able to engineer a buoyant stock market. This is the most crucial determinant of the positive sentiment underpinning valuations at the current time Lord knows, it’s not corporate earnings, which are now contracting. Now profits are an absolutely essential driver of the equity market and the downtrend may be one reason why the major averages have basically been range-bound since QE3+ was announced on September 13th (in fact, through the daily wiggles, the interim peak was September 14th). But as high as the historical 70% correlation is between corporate earnings and the equity market, it is still dwarfed by that 86% correlation with the Fed’s bloated balance sheet.
Call it the “new normal’ — a term hardly bandied about any more than “fat tall risks’ in those wonderfully prosperous 1980s and 1990s.
Just to reiterate — deleveraging, which is necessary and will inevitably blaze the trail for more sustainable organic economic growth in the future, is a dead-weight drag for the here-and-now. In fact, the total debt/GDP ratio, for the past 30 years, has a positive 82% correlation with the trend in equity values. Opinions are one thing, statistical analysis quite another. And common sense. Deleveraging is inherently deflationary. It’s a painful process that typically involves years of rising savings rates and depressed growth in domestic demand which then feeds right into the 70% that matters for the equity market which is corporate earnings.
The over-riding problem of excessive global indebtedness relative to the income-generating capacity to service the debt remains acute, notwithstanding the “don’t-worry-be-happy” market mindset This is why central banks remain in aggressive treatment mode.
Well, Rich lays his bullish claim on the classic contrarian signpost of there being rampant pessimism. But is that actually the case? No doubt the latest AAII survey does show that fewer than 30% of individual investors are bullish on the outlook for equities. As I have said time and again, this is not some sort of classic contrarian play It is a deliberate shift in investor attitudes towards how best to diversify the asset mix with an eye towards generating ‘risk-adjusted” returns. Meanwhile, many other survey measures actually point to a high level of optimism among those in the financial industry. Market Vane sentiment is 66% bullish, at the high end of the range. The Investor’s Intelligence survey shows 43% bulls but only 26% bears. The Rasmussen investor index at just under 100, much like Market Vane, currently sits at the high end of the range for much of this cycle.
Beyond the survey evidence, look at the market positioning. The ICI data show that equity mutual fund managers are sitting on 4% cash — the exact same ratio that prevailed at the market peak back in October 2007 (the cash ratio in aggressive growth funds is only 3.5%). Bond fund managers are sitting on 7.6% cash. Managers of hybrid funds have also boosted their cash ratios to 9%. Also look at how the hedge funds have re-positioned themselves in the wake of QE3+ … It is already evident that when the Fed tells the world that risk-free rates will remain at zero at least semi-permanently, capital will flow to risk assets. After a prolonged period of being cautious, the latest CFTC (Commodity Futures Trading Commission) data show that the net speculative long S&P 500 positions on the CME has swung violently since early September from a net short backdrop of 10,896 contracts to a net long position of a record 18,346 contracts (in both futures and options).
In other words, if you are bullish on equities, I wouldn’t exactly be using depressed investor sentiment or “money on the sideline” market positioning as a reason.
The counterpoint that Rich likes to make is that the cult of equities is dead and this extreme pessimism is a bullish signpost. Sort of like the “Death of Equities’ on the front page of BusinessWeek decades ago (though that front cover showed up in 1979, about three years prior to the market trough). There is this view promulgated that whatever the herd effect is in the retail investor space, you want to do the opposite. The problem with that is that in 2007, the individual investor began to pull out ahead of the institutional investor who was slow to raise cash (ostensibly buying into the consensus view of a 2008 “soft landing”… remember that one?).
First off, it is not clear when you look at ETF flows, that retail investors have totally abandoned the equity market or have completely shunned risk. For one, based on the numbers I have seen, the 42% weighting that U.S. households have as equities in their overall mix is smack-dab in the middle of the historical range. To be sure, outflows from strict capital appreciation/aggressive growth funds have been large and relentless, but a good part of that has reflected not just a shift towards ETFs but also “hybrid” or balanced funds that focus more on income orientation and less on generating alpha with beta. To be sure, and keep in mind the demographic overlay, there is a secular drive towards bond funds, but the vast majority of that (over $200 billion of net inflow in the past year) has been in “spread product”, mostly corporates. Less than $40 billion have actually flown into “safe” government bond funds. It’s not like households are hiding under the table in the fetal position — if that was the case, assets in money market funds would have expanded $90 billion in the past year instead of losing that exact amount What individual investors are doing is a deliberate asset mix shift towards more diversification, less risk, and cash flows.
Finally, in terms of valuation, I would agree with Rich that we are not at extremes. But from my lens, the market is fully priced and with earnings now contracting and record margins being squeezed, the reduced prospect of more multiple expansion is likely to leave the major averages range-bound at best over the near- and intermediate-term. When Rich was the equity strategist at Merrill, he always focused on GAAP reported earnings. I concur. And on that basis, the trailing P/E ratio is now 15.5x. No doubt that is far from the blowout peaks we saw in 2007-08 and in 2000-01, but those were the only two cycles which saw the multiple go to radical extreme nosebleed territory (and look at those two bear markets — one was double the usual decline and the other was more than triple a normal cyclical downturn). But looking at five decades of history, we see that the average multiple at the peak of the market is 16x — we are a half-point from that right now. Of course the average peak multiple is far higher than that (46x), but what should matter for investors is what the multiple normally looks like at the highs for the market. By the time the multiple actually hits its extreme peaks, the market had already rolled over for an average of eight months— because the ‘E’ falls faster than the ‘P’, at least initially as companies take the writedown hits early on.
So in a nutshell, I am sure that Rich and I will agree to disagree. From my perspective, there are slices of the stock market that I do like (even if I am not excited for the S&P 500 as a whole). And being a long-time bond hull, it is the part of the equity sphere that behaves like a bond: Dividend growth. Dividend yield (though avoiding traps). Dividend coverage. Corporate bonds. Muni’s. Canadian banks. Gold mining stocks (that now pay a dividend!). Energy and energy infrastructure. Consumer Staples. Discount retailers.
Beneath the veneer, there are opportunities. But I do not agree that the equity averages have more upside potential than downside risks from today’s levels. I do not buy into the view that the fundamentals, valuation metrics, market positioning and sentiment indices are wildly bullish. I do buy into the view that central bankers are your best friend if you are uber-bullish on risk assets, especially since the Fed has basically come right out and said that it is targeting stock prices. This limits the downside, to he sure. but as we have seen for the past five weeks, the earnings landscape will cap the upside. I also think that we have to take into consideration why the central banks are behaving the way they are, and that is the inherent ‘fat tail’ risks associated with deleveraging cycles that typically follow a global financial collapse. The next phase, despite all efforts to kick the can down the road, is deleveraging among sovereign governments, primarily in half the world’s GDP called Europe and the US. Understanding political risk in this environment is critical.
And that is my point. It is not about gross nominal returns as much as risk- adjusted returns — now more than ever. Getting it right for clients in the wealth management business means striving every single day to identify the risks, assess the risks, price the risks and then rigorously manage the risks. Having an appreciation of the risks doesn’t necessarily make you ultra risk-averse, but what it does is empower you and lead you on the path of making prudent decisions.
Richard Bernstein and I may differ on the optimal strategy at the current time to achieve risk-adjusted returns, but I am sure on that last comment we are on the same page.
I look forward to his rebuttal!
Monday, October 15th, 2012
From Gluskin Sheff’s David Rosenberg
Well, things are getting quite interesting.
The consensus view was that QE3 was going to send the stock market to the moon. Yet the peak level on the S&P 500 was 1,465 on September 14th, the day after the FOMC meeting.
The consensus view was that the lagging hedge funds were going to be forced to play some major catch-up and take the stock market to the moon too. Surveys show that the hedge funds have already made this adjustment.
Meanwhile, divergences are appearing almost everywhere — high volume on the selling days, as we saw on Friday where composite volume surpassed 2.1 billion. Breadth is bad — for every stock rising, almost two fell on the NYSE.
The defensives are outperforming, with consumer staples the leader to close out the week. Transports are lagging. So are the small caps. Financials are sagging even though this is the group that should be a prime beneficiary of the Fed’s endless largess.
Meanwhile, the VIX index continues to reveal a high level of complacency and surveys continue to highlight many more bulls out there than bears. We are sure Bob Farrell would have a thing or two to say about that from a contrary perspective.
The S&P 500 was down 2.2% for the week — the opening week of the earnings season. It is becoming apparent that investors are becoming much more discerning. Wells Fargo and .1P Morgan appeared to heat consensus estimates, yet their stock prices slid on the back of narrower net interest margins — the fly-in-the-ointment from the Fed’s ultra-low-rate policy.
Alcoa also beat estimates, but like the World Bank and IMF, downgraded the global demand outlook.
And Advanced Micro Devices saw its stock punished on the news that revenues sagged 10% last quarter in what is clearly now a demand problem across the PC industry as opposed to just a market share situation.
On top of that, Q3 EPS estimates are still coming down and now stand at -3% YoY from -2% at the start of October.
For now, the S&P 500 is sitting right on its 50-day moving average, in what the Saturday NYT biz section aptly characterized as “a technical red flag hanging over the market”. The article right below (on page B3) titled A Global Perspective: More Economic Slowing leaves one wondering whether the deteriorating macro outlook will trigger a break of this technical support line.
One thing seems sure which is that consumer sentiment surveys jumping to a five-year high (of 83.1 from 78.3 in August as per the UofM poll) are obviously no match for the earnings contraction. If they were, the market would have closed higher on Friday. In fact, not even the ECB-induced rallies in the Italian and Spanish bond markets managed to seep into firmer equity valuations as was the case through most of the summer Again, the eroding global economic outlook and negative trim in corporate profits may be too swift a current. After all, this is the first time the Fed embarked on a nonconventional easing initiative with the market overbought and with profits and earning expectations on a discernible downtrend. The flattening in the core producer prices in August and the -0.1% reading in capital goods prices attests to the exceedingly challenging top-line environment
Not only that, but the fact the pace of U.S. economic activity is still running below a 2% annual rate, which is less than half of what is normal at this stage of the business cycle with the massive amount of government stimulus, is truly remarkable. Not just zero percent rates for four years and a tripling of the Fed balance sheet but yet another year of trillion-dollar-plus fiscal deficits. It is a whole new world where everyone is worried about a fiscal cliff at a time when the budgetary gap is 7% of GDP! The fact that the Treasury market closed the week with a bid (the 10-year note yield at 1.66%) attests to the view that the bond market crowd is more consumed now with downside economic risks than on sustained large-scale deficits. Keep an eye on the debt ceiling being re-tested — the cap is $16.394 trillion and we are now at $16.119 trillion. This is likely to make the headlines again before year-end — the rating agencies may not be taking off much time for a Christmas break.
The power of the earnings cycle is so acute that the fact that Romney has caught up with Obama at the polls (46% support for both in the just-released IBD/TIPP survey) could elicit a rally in the stock market. That really says something because one would think that Wall Street would greet a Mitt victory with noisy applause.
GOLD LOOKS GOOD
Look at what the yellow metal has accomplished. And we haven’t even seen the inflation yet! Wait till that happens (in fact, at 2.6%. UofM long-term inflation expectations from Friday’s report for September came in at its lightest level since March 2009!).
What matters most are real rates, which the Fed has pledged to keep negative as far as the eye can see. It was commented on at the excellent Big Picture conference last week that none of the speakers even mentioned gold (including me!). That is a huge contrary bullish standpoint.
Even Byron Wien (see his superb interview on page 38 of Barron’s) has become constructive on the outlook for bullion, and like me, he sees it as a steady alternative to paper currencies — a currency in its own right that is no government’s liability and has a much more inelastic supply curve. I have to say that the venerable Buttonwood column on page 84 of the Economist also contained numerous reasons to have core exposure to gold — imagine one of the biggest buyers have been developed world central banks (I guess they want to get ahead of the big inflation they want to generate as debts get monetized). The article goes on to say, by the way, that the current level of negative rates is consistent with a gold price of $2,000 an ounce.
As an aside. the gold mining stocks have finally started to outperform and have a ton of catching up to do. This is one area of the market we are excited about Gold and income-generating securities. Its called the bond-bullion barbell.
Monday, October 15th, 2012
by David Rosenberg of Gluskin Sheff
Wealth Effect R.I.P.?
So the Fed is pinning its hopes on stimulating the economy via the wealth effect again, as it did when it revived the post-tech-wreck asset bubble in housing and credit in that now infamous 2003-07 period of radical excess. But here’s the rub. While there is a wealth effect on spending, the correlation going back to 1952 is only 57%. But the correlation between spending and after-tax personal incomes is more like 75%. The impact is leagues apart. And that is the problem here, as we saw real disposable personal income decline 0.3% in August for the largest setback of the year. The QE2 trend of 1.7% is about half the 3.2% trend that was in place at the time of 0E2. Not only that, but the personal savings rate is too low to kick-start spending, even if the Fed is successful in generating significant asset price inflation. The savings rate now is at a mere 3.7%, whereas it was 6% at the time of QE1 back in 2009 and over 5% at the time of QE2 2010 — in other words, there is less pent-up demand right now and a much greater need to rebuild rather than draw down the personal savings rate. This is a key obstacle even in the face of higher net worth.
What is fascinating is that the rise in net worth looks fairly tenuous. Yes, home prices have risen on the back of tighter supplies but the builders have ramped up production by nearly 30% over the past year. And the first-time buyer is dormant, which means that the key source of demand in the food chain is still missing, and investor-based buying will only go so far in terms of sustaining any further home price appreciation.
But it is the action in the equity market that is most telling. This is the first time after any major central bank incursion — QE1, QE2, Operation Twist and LTRO — that 13 (trading) days after the announcement, the stock market is lower. The S&P 500 has dropped 1% since the day of the Fed meeting whereas it was up an average of 4% at this juncture following the other four announcements. I had said earlier that the Fed has likely established a firm floor but it looks clear that the more ominous global economic backdrop has also established a ceiling — I mean, weren’t the lagging hedge funds supposed to have been piling in by now? And all of the cyclical sectors are lower which again is highly atypical—all down around 2%. And if there was a group that the Fed was really trying to support it was the Financials and this sector is down 3% along with basic materials. Go figure. The more defensive areas like Health care, Utilities and staples have outperformed, which is very rare after a QE announcement out of the Fed.
At the same time, the yield on the 10-year T-note. which is usually steady around this time following a post-QE announcement, has fallen more than 10 basis points this time around. The TSX has turned in a similar though less dramatic swing this time – Financials and Materials, which had cheapened up far more going into this than their U.S. counterparts, have actually hung in, as has the overall Canadian market (though to be fair, it is usually up 2% by now).
As the accompanied charts illustrate, one obstacle for the equity market of late has been sentiment and positioning. The Market Vane Bullishness index is at the high end of the range and as the latest CFTC (Commodity Futures Trading Commission) data indicate, the net speculative long positions on the S&P 500 and Nasdaq on the CME have already surged to record high levels. In other words, a lot of the buying power that pundits were expecting has already been exhauisted.
The pace of economic activity is weakening, with all deference to ISM. With profits faltering and wage earnings slowing down, we have a situation where Gross Domestic Income softened to a mere 1.7% annual rate in Q2 from 6.1% in Q1 and 4.6% in Q4 of last year. This was the weakest performance since the third quarter of 2009 just as the worst recession in seven decades was ebbing. In real terms, GDI actually stagnated — up a mere 0.16% annual rate, a buzz-cut from the 3.8% pace in Q1 and 4.5% in Q4, again the weakest tally since Q3 last year and the second weakest since Q2 2009. This puts the GDP slowdown in Q2 into perspective. GDP is all about spending. GDI is all about income. And it is income that drives confidence, spending, and ultimately prosperity — not the other way around.
Copyright © Gluskin Sheff
Thursday, October 11th, 2012
David Rosenberg, chief economist and strategist at Gluskin Sheff & Associates Inc., and James Bianco, president of Bianco Research LLC, talk about the outlook for the U.S. economy, labor market and Facebook Inc. They speak with Tom Keene and Scarlet Fu on Bloomberg Television’s “Surveillance.”
(h/t: Barry Ritholtz)
Tuesday, October 9th, 2012
October 2, 2012
- Highlights, key takeaways and perspective on the recent BCA Research Investment Conference.
- The eurozone crisis and China’s slowdown remain risks, but are somewhat offset by optimism about US markets.
- Politics will remain a force underpinning uncertainty and volatility.
I try to attend BCA Research’s annual conference in New York City, my stomping ground, whenever I’m able. On September 10 and 11, I sat in on two days of panel discussions on a variety of topics, and today’s report will provide some highlights and perspectives.
One of the interesting features of the conference was electronic audience polling, and I’ll share some results throughout this report. Through these polls and in conversations with other attendees, it was clear the mood was relatively optimistic, with 43% of respondents to one poll saying they were overweight risky assets. However, the mood among many of the panelists was decidedly less optimistic.
Can the euro be saved?
- Bernard Connolly, chief executive officer of Connolly Insight LP; his 1995 book, “The Rotten Heart of Europe,” outlined the flaws in the proposed euro project and cost him his job at the European Commission
- Dhaval Joshi, BCA’s Chief European Strategist
Connolly presented the negative view on the euro, stressing that budget deficits and wide yield spreads in the eurozone periphery are symptoms of the problem, not the problem itself. He views the single currency project as fundamentally flawed from the beginning and said it will be “virtually impossible to sustain.”
Connolly outlined several possible resolutions to the eurozone crisis, each of which has problems:
- Relying on austerity to squeeze costs in competitive countries would bring depression, default and—most importantly—social and political upheaval. Complicating the problem is the fact that Ireland and Spain experienced housing bubbles four times larger than that of the United States. Defaults and bankruptcies could mushroom in these countries.
- Massively depreciating the euro would lead to an unacceptable (≈70%) rise in inflation in Germany.
- Moving Europe to a full transfer union would require a perpetual transfer from Germany of about 10% of German gross domestic product (GDP).
Connolly said he believes that European Central Bank bond purchases will only delay required adjustments in peripheral countries and allow debt ratios to continue to rise.
Joshi agreed that Europe’s monetary union had fundamental flaws from the outset, but he focused more on worries associated with Germany and its “export bubble” and “lopsided economy,” with net exports having been the virtual sole contributor to growth since the introduction of the euro. This means Germany has become highly vulnerable to swings in global demand, in addition to being the global “shock absorber.”
The audience was asked whether Germany’s hardline attitude was justified, and voted overwhelmingly that it was:
Source: BCA Research Inc., as of September 18, 2012.
Joshi’s key question is whether the imbalances are corrected in a violent V-shape through euro disintegration, or more gradually in an extended L-shape, with the monetary union kept largely in place. He believes most politicians (and voters) would prefer an L-shaped outcome versus a depression.
At Schwab, we believe the flaw of the euro—a common currency that has shared monetary policy but disparate fiscal policy and cultural differences—has been exposed by the sovereign debt crisis. However, eurozone countries will have a difficult time “checking out” due to the high costs of a currency breakup. While continued accommodations for Greece’s “special case” may not continue, they demonstrate the commitment of policymakers to try to keep the euro together.
Debating China’s economic future
- Michael Pettis, professor of finance, Peking University
- Victor Gao, director of the China National Association of International Studies; former translator for Deng Xiaoping
Pettis said he believes China faces an inevitable and painful transition, with economic growth falling to a 3-4% rate in the next decade. Its growth model involves a systematic transfer of wealth from the household sector to support growth, and three mechanisms facilitate this process:
- Undervalued currency: a direct subsidy on the net export sector, but a consumption tax on households.
- Widening gap between Chinese wage growth and productivity growth: reduces labor’s share of GDP.
- Financial repression: low interest rates transfer wealth from savers to borrowers.
Pettis said he believes that as marginal returns on capital slow, it will become more difficult to find economically viable projects. China’s savings rate will need to decline and its consumption-to-GDP ratio must increase, which will only occur if household income captures a larger share of GDP. Pettis outlined four policy options:
- Reverse transfer mechanism from households to other sectors, leading to a sharp increase in the value of the yuan and potential major recession (unrealistic).
- Gradually reduce distortions, which could take a decade (they’ve run out of time).
- Massive privatization program to transfer wealth from state sector to households (politically difficult).
- Expand government debt to absorb private-sector debt (possible, but economically inefficient).
Gao countered with a far-more-upbeat assessment, though he liberally relied on history and China’s great transformation over the past three decades. He said he expects China’s economy to continue to grow at close to 8% thanks to four megatrends he doesn’t believe will change: industrialization, modernization, urbanization and globalization.
At Schwab, we believe that as China’s economy matures and shifts from over-reliance on government investment to increased private consumption as a percent of GDP, slower growth is likely the new normal. However, this transition won’t be accomplished overnight; the government will likely need to enact market-based reforms and reduce its grip on the economy, and the transition could be accompanied by bumps in the road.
Our view on China’s economic trajectory is in keeping with the results of a poll during the conference:
Source: BCA Research Inc., as of September 18, 2012.
US economy, policy and market outlook
- Norman Ornstein, resident scholar, American Enterprise Institute
- David Stockman, former budget director for President Ronald Reagan
- David Rosenberg, chief economist, Gluskin Sheff and Associates
- Laszlo Birinyi, president and founder, Birinyi Associates
- Richard Bernstein, CEO and founder, Richard Bernstein Advisors
Ornstein spoke over lunch on day one and presented three key themes:
- The high level of political dysfunction in Washington. The key problem is a shift by both parties toward more adversarial parliamentary-style interaction within a system designed to be based on consensus-building.
- Political dysfunction and gridlock breeds disenchanted voters. A culture has evolved in which politicians are no longer held accountable for spreading lies. Biased reporting in the press amplifies differences between parties and makes it difficult for voters to identify those responsible when things go wrong.
- Politics will remain a source of volatility for markets if Barack Obama is reelected. A Mitt Romney win and Republican control of the Senate could lead to a “mother of all reconciliation” bills that repeals the Patient Protection and Affordable Care Act, makes the Bush tax cuts permanent, eliminates sequesters and turns Medicaid into block grants.
I wholeheartedly agree that more years of infighting and discord in Washington is the most likely outcome, regardless of the election results, and that politics (globally) will remain a source of uncertainty for markets.
Stockman followed Ornstein and unleashed a furious attack on Federal Reserve policy on the grounds that it’s creating an addiction to cheap money and enabling the government to spend beyond its means. He said he believes that aggressive Keynesian monetary and fiscal policies have prevented a cleansing of financial imbalances and have contributed to the massive build-up of debt over the decades (I couldn’t agree more).
Stockman said he believes the fiscal governance process is broken and that both Democrats and Republicans have become “free lunch” parties, telling voters fairy tales about the fiscal mess. He also indicated that he believes Congress will only be able to manage compromises that last three to six months, and that the US Treasury bubble will burst at some point, resulting in a severe recession.
Rosenberg was also characteristically gloomy, saying that he believes the United States is not decoupling from the rest of the world and that he expects a shock in trade numbers in the next several quarters.
Both Birinyi and Bernstein were more optimistic, making a strong contrarian bull case for US stocks. Bernstein’s “Wall Street” sentiment indicator (tracking strategists’ stock-allocation recommendations) is at its lowest point since tracking began in 1986.
Bernstein said he believes the problems in the rest of the world will ensure a continued flight to safety into dollar assets and that US stocks will continue to outperform global benchmarks. He acknowledged the risk that earnings have likely peaked, and if the dollar appreciates, small-cap domestic stocks will likely outperform larger-cap multinationals. (I agree with this assessment.)
Birinyi posited that there’s no “average” or normal bull market—that group rotation exists but is random. He said he believes we’re in the fourth and final leg of the bull phase that could lead to a 1,500 level in the S&P 500 index by the end of this year.
Although the outlook among many panelists, regardless of topic, was relatively gloomy, the outlook of the audience was a bit more optimistic (including yours truly). Yes, the eurozone is still a mess, China’s growth is weaker than many believe, and neither the Fed nor US politicians are distinguishing themselves. But at some point, the negative tail risks get priced in, leaving an opening for positive tail risks. I think that’s what’s been driving stock prices higher, and I continue to believe the US market will outperform most other global indexes.
One of the final poll results is consistent with my view:
Source: BCA Research Inc., as of September 18, 2012.
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All expressions of opinion are subject to change without notice in reaction to shifting market conditions. Data contained herein from third party providers is obtained from what are considered reliable sources. However, its accuracy, completeness or reliability cannot be guaranteed.
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Tuesday, October 2nd, 2012
by Ilene, Market Shadows
As we noted last week, the global economy is slowing down, while the stock market continues to perform well. This week, we explore this disconnect in greater detail.
David Rosenberg describes six key variables that affect the stock market. These variables are: liquidity, fund flows, technicals, valuation, sentiment, and fundamentals. (Here Is How Much QEternity Has Already Been Priced In) The relative influence of these factors changes over time.
Liquidity: Quantitative easing (QE) has been supporting the stock market. The latest, QE-Infinity (or QE3), results in a new $40 billion/month cash injection into the Primary Dealers (PDs) accounts.
David’s research indicates that every $40 billion of QE added to the Fed’s balance sheet adds about 20 points to the S&P 500.
The chart below shows one way to quantify the Fed’s money-printing ways on the stock market:
Describing the chart, Phoenix Capital Research wrote, “the New York Fed itself has openly admitted that were it to remove the market moves that occurred around Fed FOMC meetings [the times when the Fed announced new programs or hinted at doing so], the S&P 500 would be at 600 today…” (Draghi’s Bazooka Fired Blanks)
The chart suggests that market participants were front-running the news. But had the increase in stocks been driven solely by anticipation, stocks should have later sold off. They didn’t. The higher prices were sustainable because liquidity was added to the financial system through the PDs–beneficiaries of the Fed’s QE programs.
In a ZIRP (Zero Interest Rate Policy) environment, with the Fed printing money and the Dollar losing value, “risk on” trades became increasingly appealing and money moved into stocks and commodities. The PDs also took advantage of more complicated investment strategies. According to Michael Hudson, the $800 billion QE2 was used by the banks to speculate on currency and interest rate arbitrage. They borrowed money at 0.25%, lent it to the BRIC countries at much higher rates, and then pocketed the interest rate arbitrage. Contrary to story line, the banks did NOT put this money into the economy. “The reality is that ever since QE1 and QE2, every time there’s a loan, the banks reduce their loans to businesses, they reduce their mortgage loans, there’s less mortgage refinancing, and in fact, the banks use the money to gamble, mainly abroad in foreign currency and interest rate arbitrage…” (QE3 = Jobs for Wall St.)
Fund Flows: Mutual funds and hedge funds have been underperforming the S&P 500. These funds have to buy the market to appear like they’re keeping up with the S&P benchmark.
Technicals: Technical analyses have been bullish. (Market Shadows includes commentary by Allan Trends, Springheel Jack and Lee Adler – they have been bullish recently.)
Valuation: Forward P/E ratios have been at the high end of the range for the past 20 months at 14x. The Shiller cyclically adjusted multiple is 25% above historical norms.
Sentiment: The shorter timeframe for the AAII Investment Survey is neutral, but longer term is bullish. David Rosenberg opined, “The bull camp is getting crowded — problematic from a contrary standpoint.”
Fundamentals: The world’s major economies are in slowdown mode. A question being raised in the financial blogosphere is whether the US is in or about to enter a recession. And if so, what is the likely effect on the stock market?
It might be expected that a recession would profoundly influence stock prices because, logically, lower economic growth is correlated with less spending, lower earnings, missed expectations, and lower stock prices. But such fundamentals are just one of many influences on the stock market. Lately, they have not been strong influences at all.
In The S&P 500 and Recessions, Doug Short examined whether recessions have led to declines in the stock market, and/or whether declines in the stock market have foreshadowed recessions. Doug’s chart below shows the market-recession correlation since the mid-1950s, with the daily closes of the S&P 500 overlaying periods of recessions (grey).
The S&P often peaked before a recession began and bottomed before it ended. Four of the nine recessions since 1957 saw the index higher at the end of the recession than at the start.
Describing the chart Doug wrote, “Since the inception of the S&P 500 in 1957, there have been 9 recessions and 9 bear markets (20% or greater declines). However, three bears were not associated with recessions, and three recessions happened without a bear market, although the 1990-1991 recession had the ultimate “near” bear with its 19.9%…
“Market indexes and recessions are two very different data series. The closing price of the S&P 500 is a real-time snapshot of equities. In sharp contrast, recession boundaries are determined many months, sometimes a year or more, after the fact, for both the starts and ends (peaks and troughs). The NBER makes its call after lengthy deliberations over economic data that has been subjected to extensive revisions.
“Economists often make generalizations about business cycles that suggest a substantial commonality among them. But that’s true only at a 20,000 foot level (and on a partially cloudy day). Recessions are dramatically different from one another if viewed within their individual economic and market contexts. Exogenous events can play a role…
“The US economic recovery since the official trough in June 2009 has been much weaker than hoped, and there are many financial pundits who agree with ECRI’s latest assertion that a new recession is underway, a view which, I would counter, is not supported by the Big Four economic indicators.”
The normal business cycle results in periodic recessions, but the character of these recessions can vary widely. The relationship between the stock market and recessions can also vary widely.
Economists and commentators disagree about whether the US is in a recession. Recessions are not declared officially until after substantial evidence accumulates over time. Current signs that the US is in the early phases might be recognized, in retrospect, but that isn’t very helpful in answering the question NOW.
Mish Shedlock argued that a recession in the US began in June: “I am very comfortable with pegging of the start of the recession in June and I expect more downward revisions in GDP and employment are on the way.”…
“Unexpected weakness and downward revisions are hallmarks of the beginnings of recessions. And so it is with durable goods. Economists had forecast a gain, instead there was a 1.6% drop. Moreover July was revised lower as well.
“Bloomberg reports Orders for U.S. Goods Excluding Transportation Unexpectedly Drop: ‘There was broad-based weakness,’ said Tom Porcelli, chief U.S. economist at RBC Capital Markets… ‘What this now means is that capital expenditures are now going to probably fall for the first time since the recovery started. It remains a terribly challenging backdrop in the U.S.’…” (Durable Goods Orders Ex-Transportation “Unexpectedly” Drop, Down Third Month, July Revised Lower; GDP +1.3% Second Quarter; June Recession Call Looking More Likely)
Writers at Zero Hedge are also in the Recession Now camp: “QE1, QE2, Operation Twist 1, Operation Twist 2, a Fed balance sheet that is now expected to be $5 trillion in 2 years, and all we get is a lousy manufacturing economy that according to the Chicago PMI just dipped into contraction, or for all intents and purposes, recession, printing its first sub-50 print, 49.7 specifically,… But not all hope is lost: at least prices paid soared for the third consecutive month… Cue not just recession, but stagflationary recession… Time to start pricing in QE X to be followed 24 hours later by QE X+1. The central bank cartel is starting to lose control.”
Whether we are in, on the brink of, an inevitable excursion into recessionary times, the US economy is weak, as are the other major world economies. The race is on to print money and devalue currencies, and this supports more risky assets such as stocks and commodities. This is the current theme of the markets and why the economy and stocks are not moving together. Fundamentals have taken a back seat to Liquidity, and this trend is likely to last into the near future.
“A veritable chorus of large US corporations has chopped their forecasts down a few sizes, citing the China slowdown, wobbly demand from emerging markets, the ongoing fiasco in Europe, or weakness in the US…
“But you wouldn’t know it from the stock markets, which are supposed to predict future turns in the economy better than any other measure, based on the collective wisdom of innumerable astute market participants—or rather computers, algos, and fat fingers. The S&P 500, for example, is up 22% over the last 12 months. A phenomenal run…
“That the CEO Economic Outlook Index evokes the dark days of double-digit unemployment is not a particularly good sign. It crowns a pile of slashed forecasts from bellwether companies. The old-fashioned among us would expect stock markets to have anticipated that corporate downdraft. But that hasn’t happened.
“If QE, QE2, QE3, the bubbly expectations of QE4, and of course QEx have accomplished anything [read... ‘Forceful and Timely Action’ to Nowhere], it is the miraculous decoupling of the stock markets from reality. Gravity can be turned off, apparently, in this new QE world of ours where no one has gone before. But then, gravity has the nasty habit of reasserting itself at the worst possible moment.” (The Miraculous Decoupling Of Reality, For Now.)
So when will gravity reassert itself? We don’t know but will be watching for signs of falling debris as the foundation of our house of cards starts to waver.
Also in this week’s MarketShadows Newsletter:
Springheel Jack’s TA
Allan’s Trends – Shorting the Nasdaq
Virtual Portfolio – House-cleaning
Thursday, September 27th, 2012
Global economic fundamentals are awful, bearish divergences are occurring everywhere, investor sentiment is nearing bullish extremes, political risks remain high and last week’s market performance can be summed up in four words – ‘lack of follow through’. As Gluskin Sheff’s David Rosenberg explains, more than two-thirds of the rally points the stock market has enjoyed since the summer-time lows occurred around central bank policy announcements. So the market is really a one-trick pony here, breathing in the fumes of central bank liquidity.
David Rosenberg, Gluskin Sheff: BUMPY ROAD
What the stock market lacked last week can be boiled down to two words — follow through. It’s as if all the QE and then some got priced in the week before. Not even the ballyhooed introduction of the iPhone 5 managed to elicit much excitement. It was interesting to see the Dow fail to hold onto its early gains on Friday and close with a 17 point loss and to see the sector leaders narrow to a group of defensives like health care and telecom services_ The financials and materials segments were very soft and yet in the past these were the major beneficiaries of Quantitative Easing. For the week, the S&P500 dipped 0.4% — which was not supposed to happen. What was supposed to happen, as the elites told us, was that the lagging hedge funds were going to throw in the towel and chase this market. Everyone expects this to be a major source of buying power.
Alas, but at what price level?
At the same time, what if the bulls who lucked out this year because they hung onto Ben Bernanke’s arm decide to take profits or at the least lock in their gains? Or what if there is no progress made on the fiscal front and we go into year-end with the gnawing realization that top marginal capital gains tax rates will be heading back to 43.4% on January 1 from the current 15%? It may be a widely-held view but it is no slam dunk that we finish off 2012 with the double- digit returns — twice what is normal — that have been posted thus far (for more proof, have a look at Money Managers Take a Timeout From Stocks in today’s WSJ. And the best quote goes to “nothing the Fed has done has increased earnings expectations’).
Further on the political front, it shouldn’t be lost on those who are proponents of capitalism that President Obama now enjoys a 49% approval rating — it is up six points in the past year (and election handicappers should note that this is the exact same thing that George W. Bush had at this same juncture of the 2004 campaign — which he won handily against another gaffe-prone opponent).
Interestingly, prices are up impressively this year, but trading volumes are down around 20%. Yet another non-confirmation.
And its not as if the equity market has been rallying off news at it pertains to the fundamentals like the economic data and corporate earnings. Indeed, more than two-thirds of the rally points the stock market has enjoyed since the summer-time lows occurred around central bank policy announcements. So the market is really a one-trick pony here, breathing in the fumes of central bank liquidity.
The global economic fundamentals are awful. China’s industrial sector is in decline_ France’s PM I data is at a 41-month low, and while Germany did manage to pull off an upside surprise, the whole euro area now has its manufacturing sector behaving as though it is 2009 all over again_ Italy just sharply cut its economic growth forecast (and the stock market there was clocked for a 4% loss last week), shortly after the Japanese government downgraded its own assessment of the economy. Declines occurred in U.S. household employment, real wages, Industrial production and core retail sales. In other words, this is not QE1, when the recession was coming to an end. This is not QE2 or Operation Twist when the economy stopped looking as though it was going to do a “double dip-. No. this latest round of central bank manipulation is happening at a time when there is no sign of an imminent turnaround in the economy, and the weakness has gone viral. The real problems for investor risk appetite comes if we see signs that inflation is heading higher which will limit what the Fed can do, or if we see the economy falter which would then expose Bernanke as the non- wizard that Toto exposed behind the curtain and the Fed as pushing on a string.
Investor sentiment is not at a bullish extreme yet, but it’s getting there — at just over 54% bullish sentiment in the latest Investors Intelligence survey. The wedge between the bulls and bears is flirting with the 30-percentage-point spread that typically signals interim market tops.
Earnings expectations are far too optimistic and destined to come down. The consensus has operating EPS accelerating to a 13.4% growth rate in 2013 from 5.4% this year. But with margins at cycle high levels (9.4%, rivaling the 2006 record, just as the market was about to put in its last gasp to a new high) ;and 30% above long-run norms, it will be difficult to see EPS growth that strong absent a return to vigorous corporate pricing power. And with the P/E multiple for the overall market already back to the high end of the range for the past two years, what I see at best is a sideways moving market from here. Some pundits will use interest rates as an excuse, but the weekend WSJ provided some nifty insight showing that the market multiple historically was 12x when the 10-year real bond yield was negative (versus around 14x now).
I don’t know but a 12x multiple on a forward earnings stream that will likely be flat around $100 in the coming year doesn’t sound like a market that has a whole lot of upside from here (or until we get another announcement from a major central bank).
There are various non-confirming developments taking place, and Dow Theory advocates know exactly what I am talking about as the Dow Transports slumped 5,9% this past week, the largest decline since November of last year That this ultra-cyclically sensitive sector is down 2,2% for the year at a time when the S&P 500 is up 16% is one of the great anomalies for 2012.
The railroad stocks not only sagged 7% last week but were also the fourth worst performer in the IBD’s 197 industry group. This is a warning sign, make no mistake, underscored by the last week’s guidance cuts by both FedEx and Norfolk Southern,
As someone from Miller Tabak put it to the WSJ this weekend:
This is a major divergence that should not be ignored. It tells me the risks of being in the market at these levels is growing. The Transports are the first major index to reflect an underlying change in the market. The market is now saying ‘yes, the economy does matter’. You can’t close your eyes and buy everything anymore.
Pretty heady stuff.
China is another anomaly as its stock market suffered its steepest decline in nearly a year as the Shanghai index closed last week at its lowest price since 2/2/12. It is down 8% for the year, and this is likely important insofar of what it is pricing in for the world’s second largest economy. It’s more that just the islands dispute with Japan and the looming political transition – profits there are in a recession, having contracted 2.7% this year and the diffusion measures of industrial activity flashed an 11th month in a row of receding manufacturing sector.
And what about Europe. Yet another non-validation. The stock market there, with an 11x forward multiple, 20% below normal, is close to telling us that the recession is getting worse. Since Super Mario embarked on his newest bond buying program in September 6th, Spanish two-year bond yields – the benchmark for global risk trades – have jumped 40 basis points.
What makes QE3 different and maybe even less potent than its predecessors is that the trend in global economic activity is still down. In the prior QEs, activity was already reviving and actually this may have played a more significant role in stimulating investor ‘animal spirits’ than the actual liquidity boost. Let’s not also forget that earnings, both operating and reported, are now contracting sequentially. And the ISM is in a multi-month sub-50 pattern. This was not the case during these other QE episodes and serves up a greater hurdle for market performance this time around.
Friday, September 21st, 2012
On September 15, 2008 (aka Q3) 2008 everything broke. What happened next has been a piecemeal triage by one (then all) central banks to stop the crunch in the world’s credit markets, by monetizing the bulk of public issuance (i.e., creating money out of thin air), and thus keeping GDP from collapsing, while private sector debt creation has stalled and in many cases has been put in reverse.
And while the US household balance sheet which we showed earlier is important from a stock perspective of asset, liability and wealth allocation, as everyone knows money (if not wealth) comes from credit, and should the credit formation system be shuttered it means game over. So what, according to the Fed’s Flow of Funds, has been the credit creation, and destruction, since Q3 2008, i.e., during the neverending Great Depression Ver 2.0? Well, of the $2.8 trillion in total debt created (table L.1 in Z.1), $5.8 trillion or 208% has come from, you know it, Uncle Sam: this is the amount by which US Treasurys have risen, and will continue to rise as long as the two key sectors continue to delever. These sectors are the Household at $855 billion in deleveraging in the past 4 years, but most importantly the Financial Sector who have unwound a whopping $2.9 trillion in debt since Q3 2008. Which brings up an interesting question: why has the Financial Sector refused to lever, and why did it delever by $162 billion in Q2 2012 – the most since Q2 2010?
Simple – regulations such as Basel III (which will eventually be scrapped) and lack of confidence in a system, in which the central counterparty is and will be the central bank. In other words, the more Treasury issuance is monetized by the Fed, the greater the penetration of central-planning, the lower the confidence in the system, the greater the deleveraging by everyone else, until finally, as David Rosenberg predicted, the Fed owns everything! Is this the biggest Catch 22 of the modern Depressionary market? You bet.
And this is how the quarterly change in credit has looked like in the past 6 years.
Monday, September 17th, 2012
David Rosenberg, Gluskin Sheff: BernanQE Plays With A New Deck
It would be glib to ask “well, wasn’t QE3 priced in?”
What the Fed did was actually much more than QE3. Call it QE3-plus… a gift that will now keep on giving. No maximum. No time limit. The Fed also lowered the bar on what it will take, going forward, for even more intervention.
The Fed announced that it will buy $40 billion per month in MBS (together with the on-going Operation Twist program, this brings total asset purchases to around $85 billion monthly through year-end), but the press statement contained an open-ended commitment to QE until labour market conditions not only improve, but do so ‘substantially”. This is a radical shift.
Before, the QEs had an explicit maximum limit in magnitude duration. That is no longer the case — $40 billion in MBS buying month in, month out, perhaps until such time that the Fed owns the entire market (the Fed already has $843 billion of Agency MBS on its balance sheet as it is — if this is truly Japan and it takes another ten years for the economy to improve “substantially”, the Fed will end up owning the entire market).
Prior QEs seemed predicated on relapses in economic growth (or at least no follow-through). This was the case with QE1 in March 2009, QE2 in November 2010 and Operation Twist just over a year ago. Now the economy has to strengthen dramatically and if it doesn’t – the Fed is clearly targeting the jobs market and specifically on the unemployment rate here – then the spectre of even more balance sheet expansion will remain fully intact. We could soon be attaching Roman numerals to future QE actions (January 31st 2014 is Bernanke’s last day as Fed Chairman and that is a loooong way away).
The payroll data always move the market but now more than ever and the Fed’s explicit goal of generating “substantial” improvement in the jobs market will ensure that this ‘bad news is good news’ psychology will remain fully intact (why the stock market so easily managed to shrug off last week’s data – this new normal of bad news being good news is now going to be more fully entrenched for the market). And with the Fed targeting mortgages, it is clear that it views housing as the transmission mechanism for its objective of strengthening the jobs market. So each housing indicator going forward is also going to very likely elicit a stronger market reaction than normal – remember, because the stock market is addicted to QE, weak data can still be expected to be supportive. A notable improvement in the data will be even more supportive because the Fed will still keep the hope alive of more QE even if economic conditions get better.
I have to stress this but anything less than “substantial” is just not going to cut it for the Fed – I don’t know how that is defined numerically, but if the economy and specifically the jobs market does not go gangbusters, more QE can be expected. And it won’t always be in MBS – the Fed came right out and said that it will also “undertake additional asset purchases and employ other tools as appropriate until such improvement is achieved in the context of price stability”.
That reference to “price stability” is a bit comical because in the prior rounds of unconventional stimulus: market-based inflation expectations (from the TIPS market) were sub-2% and falling. Going into today’s meeting, they were 2.6% and rising. This, for a central bank that spent an inordinate amount of time talking about how important it was to prevent inflation expectations from becoming unhinged when it was busy tightening policy in the 2004-2006 rate-hiking cycle. The times, they are a changin’ (in other words, the price stability objective has a big fat R.I.P. on its tombstone). This is why gold swung from a moderate decline to a huge gain yesterday afternoon, and the DXY is breaking. It is clear that out of its dual mandate, a lower unemployment rate right now clearly trumps any concern over higher inflation expectations (whether justified or not).
Equities have ripped to the upside. Commodities are bid. Gold has broken out. The U.S. dollar is sliding. Yet the bond market refuses to buy in. The yield on the 10-year note has remained stable through this entire dramatic response to QE3 (and pledges for more). The Fed announced that it was buying mortgage-backed securities, not Treasuries, so it is curious as to why the bond market is not selling off dramatically. I can count numerous Fed meeting days when the stock market rallied sizably and bonds sold off alongside the reflationary view. I recall all too well the June 26, 2003 FOMC meeting when the Fed cut rates for the last time in that cycle and told the market it was on its own because the economic clouds had finally parted. The Dow ran up more than 100 points from the intra-day low that session and the 10-year note yield jumped 17 basis points, basically ratifying the view of the equity market at the time. But this time around, the Treasury market remains the odd man out on this new pro-growth view evident in the pricing of other asset classes. For any perma-bull out there, Mr. Bond is like having a mosquito in your ear on the putting green.
So from a markets standpoint, let’s talk about what all this means.
- The Fed is setting us up for more risk-on/risk-off volatility. Long-short strategies or relative value strategies are perfectly appropriate.
- The Fed extended the period of ultra low policy rates through to mid-2015 (one FOMC member is at 20161) from the end of 2014, which will nurture a low yield environment even further. Not only that, but the Fed said that “a highly accommodative stance of monetary policy will remain appropriate fora considerable time after the economic recovery strengthens” which means that even if growth miraculously manages to accelerate earlier than expected, the Fed is not going to begin raising rates. The age of “pre-emptive” tightening is long gone. This nurturing of a low policy rate environment for years to come will continue to underpin the income (dividend) theme in the stock market.
- The fact that the Fed is embarking on an even more aggressive course with inflation expectations on the rise should be viewed constructively for gold and other precious metals (and gold mining stocks).
- The Treasury market is like the brake lights on a car – we need to acknowledge that it is not signalling better growth ahead. Screen for earnings visibility and less cyclicality. Bonds usually have the economy right.
- Corporate bonds should be a beneficiary as the Fed continues to anchor a low interest cost environment and as such, correspondingly keep debt- servicing charges and default risks at bay.
I don’t think this latest Fed action does anything more for the economy than the previous rounds did. It’s just an added reminder of how screwed up the economy really is and that the U.S. is much closer to resembling Japan of the past two decades than is generally recognized. Maybe in the central bank world of the “counterfactual” these QEs prevent a worse outcome but the most radical easing in monetary policy ever recorded has not stopped this post-bubble-bust American economy from posting its weakest recovery ever whether measured in real, nominal or per capita terms.
The economy is saddled with too much debt, a shortage of skills, bloated government, an uncertain tax rate outlook, the costs associated with Obamacare, banking sector re-regulation and a spreading European recession. Home prices may have revived of late, but there are still an amazing 22% of debt-ridden homeowners who are upside-down on their mortgage. Monetary policy is best equipped to deal with the vagaries of the business cycle but is a blunt way to deal with deep structural, fiscal and regulatory hurdles. QE has done squat for the economy and I don’t expect that to change. Even the Fed cut its 2012 real GDP growth projection for this year to 1.85% from 2.15% – for a year when typically growth is closer to 4% – and so the bump-up in 2013 to 2.75% from 2.5% has to be viewed in that context (in fact, it would seem as though for all the bluster, the level of real GDP is actually lower now at the end of next year compared to the pre-QE3 forecast… maybe this is what the Treasury market has latched on to).
It would seem as though the Fed’s macro models have a massive coefficient for the ‘wealth effect’ factor. The wealth effect may well stimulate economic activity at the bottom of an inventory or a normal business cycle. But this factor is really irrelevant at the trough of a balance sheet/delivering recession. The economy is suffering from a shortage of aggregate demand. Full stop. Perhaps most importantly, in order for the Fed’s action to have a lasting impact on the direction of the equity market, it must foster at least some significant belief that the action will lead to self-sustaining economic expansion. The scars of real family median income declining for two years in a row – the Fed’s action in a perverse way perpetuates this by forcing essential basic material prices higher – and an unprecedented five-year decline in household net worth are lingering, and exerting far more powerful dampening effect on spending and confidence than the Fed’s repeated attempts to generate risk-taking behaviour.
To the extent that the Fed is at least temporarily successful in nurturing a risk-on trade for portfolio managers, the reality is that changing the relative prices of assets does not create demand.
It just perpetuates the inequality that is building up in the country, and while this is not a headline maker, it is a real long term risk for the health of the country, from a social stability perspective as well.
Wednesday, September 12th, 2012
David Rosenberg appeared on Bloomberg yesterday with Tom Keene to discuss his outlook for the U.S. economy, and markets.
Highlights of the appearance:
Rosenberg says what’s happening right now in banking is we’re putting up 8 stop signs at every corner. The pendulum has begun swinging the other way. In the period from 2006-2008 we had leverage ratios in the banking industry of between 30-50 times, and now we’re going to run leverage ratios much lower than that, and its going to create much more stability, which is true. It’s also going to be creating less economic growth.
This was the debate that was going on in Canada during that time, when the ‘Wild West’ was being created in the U.S., and there were bankers that wanted to have a situation where we had subprime mortgages, unlimited leverage ratios, for the greater good in terms of economic growth and full employment, and we know how that finished off in the U.S.
Tom Keene brings up the fact that equity markets are up 24% in the last 12 months.
As for equities, Rosie says 90%-95% of this rally everyone’s talking about started in March 2009 and ended last April (2011), and since that time 5%-10% of this rally has basically been the ‘bulls’ fighting over the crumbs … with the support of central banks – you get the QE, you get the intervention by the ECB, and then you get a rally, and when the intervention dissipates, you get the markets rolling over.
There are sections/segments of the stock market that he likes – Dividend Growth, Dividend Coverage, Dividend Yield, there is probably 20-30% of the stock market he likes.
Rosie then asks why they don’t have more bond analysts on the show, and comments that the best performing asset has been 30-year Strip Coupons or Zero Coupon bonds, which returned nearly 50% over the past 12 months. … Keene admits that Rosenberg hit the ball out of the park on the bond call.
Keene says that the majority of people say that the bond rally is done.
Rosie retorts with “They were saying that a year ago, Tom. They were saying that two years ago, three years ago. “I would say that if the stock market, the S&P 500 had returned 50% over the past year, most viewers would know about that. The zero coupon bond … it doesn’t even make it to like page C10. The whole thing is about the stock market. Its not about ‘What have corporate bonds done? What has gold done? We’re going on 13 years in a row of it going [straight] up. And we’ve got the bond market.”
On the U.S. Economy:
Rosenberg has been right about the economy too and on inflation.
He said Fisher was wrong, Plosser was wrong, Lacker was wrong. We’ve got a Fed meeting, with a legitimate debate over what will they do. Keene asks Rosie – “What will they do?”
He replies that at the Jackson Hole meeting, Bernanke mentioned the words ‘labour market,’ ‘jobs,’ ‘employment,’ no fewer than 34 times. And then we get that coup-de-gras, which is that horrible employment number last Friday, so his sense is there is going to be some sort of announcement extending zero percent interest rates beyond 2015. QE is already priced in; the question is, “In what form?” will QE be announced.
If you go back to the 2002 “What If?” meeting, one of those options might be an “explicit interest rate ceiling for the long bond,” and that would imply not that we’re going to buy $500-600-billion of MBS which is what many Wall Street firms are talking about, but the Fed following in the footsteps of the ECB, and moving toward ‘unlimited’ expansion of the central bank balance sheet.
What does that mean?
The financial repression means that we have interest rates at zero, savers are being penalized. If you go back to Newtonian physics, which says that every reaction has an opposite and equal reaction, so you’re going to penalize pensioners, and you’re going to penalize people who don’t really spend too much in the economy, to benefit borrowers.
And that is what the Fed is grappling with, because what you want to do is, and “i’m not going to defend the Fed,” but what I am going to do is explain what they’re trying to do, which is to get the marginal propensity to spend in the overall economy, UP. To get borrowers to spend at the expense of the loss of interest income to savers …
There is going to be less credit growth for each of unit of GDP, and that means that potential GDP Growth is going to be much slower than it has been in the past 20 years. Its not as bad as ‘euro-schlerosis’ but it means that you are talking about GDP growth of 2%-2.5%, instead of 4%-4.5%.
The reason Rosenberg is still hanging on to his deflationary outlook, is because demand growth currently stands at 1%-1.5%.
He is sympathetic to PIMCO’s “new normal,” however, it does not take into account the deflationary output gap that occurs when aggregate demand growth is 1%-1.5% vs. GDP growth is 2%-2.5% (an output gap of 6% over 4 years).