Posts Tagged ‘Stock Market Valuations’
Wednesday, October 5th, 2011
Wells Capital Management’s Chief Investment Strategist, Jim Paulsen, has just released his exhaustive investment outlook. The complete report, which is longer than the following prefacing text, follows in a slidedeck, which you can either download or fullscreen.
by James Paulsen, Chief Investment Strategist
Wells Capital Management
Since its collapse in early August, the stock market has experienced extreme daily price volatility oscillating within a broad range. These emotional daily price swings reflect a skittish investor struggling with a dichotomy between extremely attractive relative stock market valuations and an array of escalating fears. Investor worries include a widening contagion from the European sovereign debt crisis, the potential for a hard landing among emerging world economies, uncertainty introduced by uncommon and confusing Federal Reserve policy actions, and the likelihood of yet another debt ceiling debate looming on the horizon.
While these concerns should keep daily price volatility elevated, how the stock market ultimately breaks from its recent trading range will probably be determined by whether the U.S. economy avoids recession. In the next several weeks, economic reports will either galvanize recession expectations or consensus fears will once again calm, embracing the likelyhood that the U.S. economic recovery will persevere. Should a recession become obvious, the stock market would likely suffer a further significant decline. Alternatively, investor greed may dominate the rest of this year should recession fears fade as investors act to take advantage of a valuation metric (about 11 times earnings with a sub-2 percent 10-year Treasury) which, without a recession, represents a fire sale!
A U.S. Recession?
An imminent U.S. recession is unlikely. First, the traditional economic policies which precede a recession are not evident. The U.S. does not possess an inverted yield curve, has not been subjected to significant short-term nor long-term interest rate hikes, and is not suffering from restrictive liquidity conditions or tight fiscal policies.
Second, can the U.S. suffer a recession when there is nothing to recess? Recessions often result from “excesses in need of a correction.” Since the last recession ended only two years ago and since it was so extreme, private sector players have thus far been well-behaved in the contemporary recovery. Are individuals paying up too much for houses today? Have consumers extinguished pent-up demands for durable goods? Is the savings rate too low (the savings rate has been hovering about a 20-year high since the recovery began)? Are household debt burdens oppressive (the household debt service burden is in its lowest quartile since 1980 and no higher today than it was in 1985)? Have banks been aggressively overextending loans? Has anyone been borrowing too much lately? Are companies overstaffed? Overinventoried? Have businesses over invested in the last couple years? Has the Fed tightened too aggressively? Have bond vigilantes raised bond yields too much? Too much fiscal tightening lately? Is anyone lacking for liquidity? Are households overexposed to the stock market today? Is optimism over the top? It is hard to see why the U.S. would experience a recession when almost nothing requires a “correction.” Indeed, before the next U.S. recession, the answer to at least some of these questions will likely be yes!
Third, despite a significant economic slowdown since early this year (annualized real GDP growth rose only 0.7 percent in the first half and real GDI growth rose by only 2 percent), the economy is already showing some signs of bouncing. After flattening earlier this year, real personal consumption is on pace to rise more than 1.5 percent in the third quarter, weekly retail chain store sales have remained relatively robust, and the annualized U.S. auto sales rate has risen by more than 14 percent since June to 13.1 million, helped by Japan bouncing back from its tsunami. Weekly unemployment insurance claims remain in the low 400,000 range, reported private sector ADP employment gains have averaged 100,000 in the last two months and layoff announcements as recorded by the Challenger Job Cuts Index have remained subdued.
Corporate profits are still robust, industrial production posted back-to-back gains in July and August, and recent reports for factory orders and durable goods shipments suggest business spending may have accelerated. The ISM manufacturing survey surprisingly increased in September to 51.6 and the ISM services survey is at a solid 53.3. Finally, U.S. net exports improved significantly in July suggesting international trade will add to third quarter growth. Overall, we expect real GDP growth to be between 2 to 2.5 percent in the third quarter— hardly a recessionary reading.
Fourth, new “policy stimulus” added in recent months should soon improve the pace of economic growth. Many worry the Fed is out of bullets and fear fiscal authorities have been neutralized by gridlock leaving the economic recovery without policy assistance. Although the abilities of policy officials may be limited, the economy has turned to “self-medication.” The national average 30-year mortgage rate has fallen from 5.2 percent in February to only about 4 percent today! Similar yield declines since the spring have been recorded by investment grade corporate bonds and by municipal securities. This “large” decline in long-term credit costs should help boost economic performance in the next several months. Both consumers and businesses should also get a boost from lower energy cost. Crude oil and gasoline prices have declined by more than 20 percent from peak levels earlier this year. Furthermore, even though the U.S. dollar has recently risen, the real broad U.S. Dollar Index is still about 10 percent lower today than it was in 2010 suggesting additional improvement is forthcoming in U.S. trade flows. The U.S. M2 money supply has exploded since June growing at an annualized pace of about 25 percent! Finally, as Japan bounces back from its economic collapse after the early-year earthquake, U.S. manufacturing supply chain problems should alleviate further in the next several months. Indeed, U.S. auto sales have already strengthened significantly in recent months as the Japanese impact diminishes.
What About Europe?
Unlike the U.S., the Euro region has been subjected to significant monetary and fiscal tightening in the last year and does exhibit characteristics of a pre-recessionary economy. However, how serious is the risk of either a recessionary or sluggishly growing Euro region for investors?
The best news surrounding the Euro crisis is it has finally gotten so bad! When the Euro sovereign debt crisis first broke in January 2010, the major players (EMU policy officials, Germany and France) perceived the problem as a political issue. Consequently, the crisis has not received any substantial assistance aimed at ending the economic and financial contagion. Only recently have the major powers in the region decided it is an economic threat and have begun to treat it more appropriately. Since officials have done so little yet to arrest the crisis, many weapons are still left in the tool box. Only recently, EMU officials finally suggested they will stop raising interest rates. Soon they will begin to lower interest rates, perhaps pursue some non-sterilized bond purchases (i.e., those that actually expand the central banks balance sheet and thus represent a true easing of monetary conditions), and even entertain a European-style TARP program similar to the U.S. approach used in 2008 to backstop ailing banks. After almost two years of smoldering into a major economic threat, there is understandably great concern the crisis cannot be controlled nor extinguished. However, the lack of success to date is primarily because so little has been done to address the crisis. This is beginning to change and will likely lead to much better results in the coming year.
The most serious threat for the U.S. economy is not a period of sluggish or nonexistent Euro region growth but rather a full-blown global financial contagion. Although possible, this seems highly unlikely in our view. First, the problems are well-known and have been for some time. A more serious financial contagion could hardly be a “surprise” which is often the most difficult aspect of crises. Second, most U.S. financial institutions do not hold large amounts of troubled sovereign securities. Third, even if a financial contagion were to infiltrate the U.S. financial system, because of responses to the 2008 U.S. crisis, the U.S. system is now very well capitalized, it has already experienced a major write down of bad debts, and is more highly liquid than in decades. Perhaps this is why for the first time, European and U.S. 10-year government swap spreads have significantly delinked. Euro swap spreads have exploded to 2008 wides while U.S. spreads remain near their lowest levels of the last decade.
The more likely U.S. fallout from the Euro crisis is a sluggish Euro region economic performance which would reduce U.S. export markets. While this is very likely, it may have much smaller impact then most fear. Outside of the Euro region, economic growth is likely to be maintained including Japan, Canada, Australia, the emerging world economies, and in the U.S. It is worth remembering that in 1990 the world’s largest economy at the time, Japan, fell into a depression from which it would not return. Nonetheless, the rest of the world including the U.S. proceeded to enjoy an economic boom during the balance of the 1990s! Today, the world economy is comprised by a new economic force (emerging world economies), which did not exist in any meaningful fashion in 1990, which should help diminish the impact of a smaller growth contribution from Europe.
How About China and the Emerging World?
A much more serious blow to the global economic recovery would be a recession in the emerging world. Despite widespread fears of such an event, we think a “soft landing” is a better description of what is happening among emerging world economies. During much of 2010, investors worried about China and other emerging economies overheating and collapsing. As a result, most emerging economy policy officials have been tightening conditions in the last year leading to a noticeably slower growing emerging world. However, now policy officials in this region are beginning to turn back toward easing policies after most economies have slowed. For example, Chinese real GDP growth has slowed to a still very robust 9 percent rate from about 12 percent last year. This is probably a healthy development and makes it more likely the global economic recovery will prove longer-lasting. Recently, China reported the second consecutive monthly rise in its manufacturing ISM survey to 51.2 in September! The easing policies now being increasingly employed throughout the emerging world suggests a quicker economic growth from this part of the globe in the coming year.
Market Signals are Flashing Caution???
U.S. recession expectations have risen primarily because several financial market indicators are providing signals which often precede a recession. That is, recession fears are due less to worsening economic fundamentals than they are being driven by worsening financial market signals.
The good news is the old adage which goes something like “the stock market has predicted 12 of the last five recessions.” While financial markets always worsen prior to recessions, poor financial market action also frequently precedes temporary economic slowdowns or panics. Consequently, it is hard to interpret the message of the markets. However, given the extraordinarily fearful, crisis-phobic culture which has dominated since 2008, a good deal of caution should be employed when relying on survey reports and market signals (markets which have been amazingly emotional driven) to access where the economy is headed. We are certainly in the middle of an intense panic. A panic which may last longer and take financial markets even lower before it is extinguished. However, fundamentally the U.S. economy remains sound, has some momentum, and because of self-applied stimulus since spring, is likely to improve in the months ahead. Moreover, Euroland problems finally seem to be receiving the “economic/ policy” attention it deserved a lot sooner. Finally, the rest of the global economy, like the U.S., is still growing (more likely in a temporary slowdown) or even growing quite rapidly (e.g., emerging world). Contemporary financial market signals, owing to the current remarkably emotionally-volatile period, may be exaggerating upcoming economic problems and underestimating the potential for an economic reacceleration.
Outlook for the Stock Market?!?
The fate of the U.S. stock market during the balance of this year will not likely be determined by Euro crisis fears, by Fed actions, by a jobs bill, or by debt ceiling debates. Rather, the stock market is likely to be driven by whether or not the U.S. avoids a recession. That is, the stock market will ultimately rally or fail based on economic data flow coming from Main Street USA.
Should the data convincingly portray a U.S. recession, the stock market will likely decline significantly further from current levels. With the S&P 500 Index currently slightly below 1100, the stock market already seems to be discounting a recessionary decline in earnings to about $70 (from the current likely yearend level without a recession of about $100). That is, based on this recessionary earnings expectation, the stock market currently sells at about 15 to 16 times which is a reasonable recession valuation given a sub-2 percent 10-year Treasury bond yield. Moreover, we believe if a recession does actually occur, “panic” will likely cause a much deeper decline in earnings producing further downside risk in the stock market.
Fortunately, we believe the chance of a U.S. recession remains quite low. If, during the next few weeks, the upcoming jobs report shows positive gains (even if sluggish) and if unemployment claims, retails chain store sales, and other timely economic data do not fall off a cliff suggestive of a recession, investor greed will likely return and begin to dominate the financial markets. If a consensus comes to believe a U.S. recession is “off the table,” the current valuation metric of less than 11 times year-end earnings while the 10-year Treasury yield is at a record low will become far too enticing.
We think a consensus which agreed the economic recovery will persist would result in a stock market willing to pay perhaps around 14 times for 2012 earnings of between $105 and $110 or a target price of about 1500! This is not necessarily our forecast for next year, but rather an illustration of the investment potential which exists should consensus recession fears fade.
The incredible daily volatility exhibited by stock prices during the last two months is frightening and tiring. It seemingly makes no sense when valuations can change so radically, so quickly, with little or no new fundamental information. However, the character of these types of markets, these periodic “gut checks,” may be what is in store for investors during this highly crisisphobic period in financial history. Our best guess is investors should try to stay focused on fundamentals and not on the “market’s daily assessment of its worst crisis fears.” Ultimately, we believe the U.S. and global economy is in a recovery—a recovery which will prove bumpy but will also likely prove persistent. And, if it does, those investors which approach this decline in the stock market as an opportunity to raise exposure to cyclical sectors will likely fare best in the coming years.
Tags: Bonds, Canadian Market, Chief Investment Strategist, Contagion, Crude Oil, Debt Ceiling, Debt Crisis, Early August, Economic Policies, Economic Reports, Fire Sale, Inverted Yield Curve, Investment Outlook, Investor Worries, Likelyhood, Outlook, Policy Actions, Price Swings, Price Volatility, Recession Fears, Sovereign Debt, Stock Market Valuations, Wells Capital Management, World Economies
Posted in Bonds, Brazil, Canadian Market, Markets, Oil and Gas, Outlook | Comments Off
Wednesday, March 16th, 2011
An Uneven Global Recovery – Lingering Effects of the Credit Crisis
by Bill Hester, CFA, Hussman Funds
What is the state of the almost two-year old global economic recovery? Do the characteristics of this recovery so far match the characteristics of the typical post-war recovery? Or are they more comparable to the periods that followed prior credit crises? How large a role are the economic backdrops of individual country’s playing in stock market valuations?
There aren’t short, simple answers to any of these questions. But they capture some of the issues that investors are currently confronting in their attempt to appropriately price global stock markets. A closer look at recent global economic performance can hopefully provide some data for the discussion.
The next few weeks may turn out to be a crossroads for global economies and stock markets. Over the past two years policy makers around the world mostly agreed on the medicine the global economy needed: add more liquidity in response to any sign of faltering stock prices or credit stress. Soon, economic prescriptions will begin to vary. The ECB will likely begin to boost short-term rates in early April as Euro-area inflation rates have climbed above the bank’s goal of about 2 percent. The Bank of England will likely respond in similar fashion later this year, although it finds itself in a tighter spot with higher levels of inflation than the Euro region, but also with output growing more slowly.
Meanwhile Fed Chairman Bernanke has made it clear that he will not be swayed by the trends in the volatile segments of inflation, like food and energy. He has suggested that the Fed will wait until the core rate of inflation pushes higher or inflation expectations rise to a greater extent before becoming concerned.
Continuing negotiations by Euro area leaders about the size and reach of the European Financial Stability Facility (EFSF) – the rescue fund created last year to help backstop sovereign debt – also provide fertile ground for disagreement. The market is sending signals that the current fixes in place may not be sufficient. Three-year government notes in Greece are now yielding 18 percent, up from less than 13 percent in January. Portugal borrowed money this week at 5.99 percent, up from a yield of 4.08 percent on bonds with the same maturity sold in September.
This recent market action forced European leaders into an emergency summit on Friday. From that meeting came important changes to the rescue fund. The EFSF will now be able to loan the full amount allotted to the fund, it will be allowed to buy sovereign bonds on the primary market, and the interest rate on loans to Greece was cut by a percentage point while the maturities of the loans were extended.
But the summit also highlighted the continuing divergences in opinions on fiscal strategies in the area, including ways to increase competitiveness, equalize retirement ages for pensioners, and appropriate tax policies. Ireland’s request for lower loan rates was denied by the group because the Irish refused to consider an increase in corporate income tax rates.
These growing disagreements in monetary and fiscal policies will likely create further divergences in economic recoveries. The health of the global economic recovery depends on which country you view it from. Some countries are performing much better than is typical for a period following a global credit crisis. Some are performing in line – or worse – than is typical for these periods.
To help gauge the recovery on a country by country level, we’ll lean on the body of work by Carmen Reinhart. In a paper published last year titled After the Fall , Carmen and Vincent Reinhart updated the research on the economic characteristics that follow credit crises. Where the book she co-authored with Ken Rogoff, This Time Is Different, looked at the immediate effects of global recessions that followed credit binges, last year’s paper extends the window of the analysis to include economic performance during the subsequent decade. Their conclusion was that economies tend to grow more slowly following credit crises, have higher levels of unemployment, and emerge with higher debt loads in relation to GDP. This period of below-average growth will often last as long as the credit surge that preceded it.
The Reinhart’s paper looked at the 21-year periods surrounding credit crises, comparing the decade following each credit crisis with the 10-year period that preceded it. To capture this style of analysis, the tables below attempt to provide a mid-recovery check-up. The tables compare the most recent data for each country to the average of that data during the decade that preceded the peak. The first table highlights changes in real GDP. For reference, the Reinhart’s found that the median growth rate of GDP following prior credit crises was about 1 percent less than the decade that preceded it.
In the table above, the average recent growth rate is about 1 percent below each country’s output growth prior to the peak. Of course, a large part of that average subpar GDP growth is due to the contraction in output in Greece. Without Greece, the average difference in growth rates is -.35%. But it’s also clear that a majority of economies are still growing at rates below levels attained prior to the peak. This is sobering considering the tremendous amounts of liquidity introduced into global economies during the past 18 months. Of the countries in the table, two-thirds of them currently have growth rates below longer-term averages, despite economic slack that would normally allow them to grow at much higher than average rates.
The Reinhart’s also found that high unemployment rates were sticky in developed countries following credit-related recessions. The median unemployment rate in developed countries was about 5 percentage points higher following these periods. The table below lists recent unemployment rates versus prior averages. The average difference among the countries is about 2 percentage points. As with GDP growth, there are large divergences. Peripheral Europe is enduring high rates of unemployment, with Ireland, Spain, Portugal, and Greece having unemployment rates that are averaging 6 percentage points above pre-crisis levels. More than 75 percent of the countries still have unemployment rates higher than the pre-crisis average.
Germany is an example of a healthy economic recovery. Germany’s unemployment rate is currently at nearly a two-decade low. These first two tables highlight the large extent to which the Euro area is relying on Germany’s recovery.
Looking at the labor data in this context also highlights how weak employment growth has been in the US. The US unemployment rate sits 4 percentage points above the pre-crisis level. In this light, the US job recovery’s best comparison is with peripheral Europe.
The data on changes in the rate of inflation that followed credit crises showed less agreement in the Reinhart’s work than did output growth and unemployment trends. Highlighting the two credit crises that were global in scale – 1929 and 1973 – deflation followed the former and very high rates of inflation followed the latter. Currently, divergences in global inflation rates are rising. Greece and the UK are experiencing high rates of inflation, versus generally accepted target levels. Ireland is experiencing low rates of inflation, as real estate prices continue to founder.
The table also highlights why the monetary policy trends among the major central banks will likely continue to diverge this year. While the UK confronts inflation rates at twice their longer-term average, the US inflation rate is still about one percent below its average prior to the crisis.
Real Interest Rates
Forward looking measures of growth are suggesting that sub-par economic growth will likely continue. As John Hussman recently noted , high real interest rates can signal opportunities for productive investment and future economic growth. During the technology boom of the 1990′s, real rates in the U.S. stayed persistently high, and were followed by strong GDP growth. These same trends can be seen globally. The graph below plots real rates (the 10-year yield minus consumer inflation) in Britain, along with GDP growth a year later.
Current global real interest rates are uninspiring. The table below compares the recent real rate for each country in our sample to the pre-crisis average. It’s important to highlight the countries with high real rates: Ireland, Greece, Portugal, Spain, and Italy. That’s also a list of countries where investors are unsure they’ll be paid back par on their bonds, so the high rates reflect significant default premiums. Outside of that group, all of the other countries currently have lower real rates relative to their pre-crisis average rate, either because of low interest rates or rising levels of inflation, suggesting potentially sluggish global growth going forward.
Debt and Economic Recovery
The tables above show that there’s been variation in how developed countries have recovered from the depths of the global recession. Why has this variation occurred? One reason is different levels of public debt. Countries that entered into the crisis with near-balanced budgets and didn’t need to issue debt to prop up their banking systems now have more flexibility and are generally experiencing healthier recoveries. In these countries output is growing more quickly, unemployment rates are falling, and inflation levels are staying low.
The graph below compares the growth in output for each country in our sample from June 2009 through the end of last year (where fourth-quarter data is available). That recent growth is compared to each country’s public debt to GDP ratio.
The graph below compares the changes in unemployment rates since June 2009 relative to debt to GDP ratios. Again, generally less indebted countries have seen their unemployment rates fall, or rise modestly, while more highly indebted countries has experienced rising jobless rates.
Finally, the graph below compares the changes in the level of inflation since June 2009 to each country’s debt to GDP ratios. Higher indebted countries have seen inflation rates rise more quickly relative to countries with healthier balance sheets.
Something to keep in mind when looking at these charts is that many of these countries will move outward on the horizontal axis as their debt loads in relation to GDP grow, especially when age-related liabilities are included in the analysis. Recent research from the BIS suggests that debt to GDP ratios will rise significantly over the next decade, growing to 300% in Japan, 200% in Britain, and 150% in Belgium, France, Ireland, Greece, Italy, and the United States. These increases would represent ratios of debt-to-GDP that are 60% higher than current levels, on average. (Japan was left out of our analysis only because its debt to GDP ratio is already so high that it visually distorts the trends of other developed countries.)
That means that a greater share of countries may take on the qualities of those economies currently saddled with high debt loads: slower economic growth, stubborn unemployment, and inflation rates above standard comfort levels. And these macro-economic risks correlate directly to stock market risk. The graph below displays the change in stock-market multiples (using MSCI price indexes and fundamental data) since June 2009 and the ratio of debt to GDP. The graph shows that investors continue to be sensitive to economic and default risks, containing the stock market multiples of the highly indebted countries, versus those with lower debt loads.
The health of the global recovery depends on which country it is viewed from. When compared to the decade ending in 2007, a majority of developed countries are currently growing more slowly, have higher rates of unemployment, and have higher levels of inflation. Some – like the countries of peripheral Europe – are deeply mired in standard post-credit crises characteristics. There are exceptions. Notably, Germany is growing at twice its long-term average, with very low relative levels of unemployment. Stock market investors are showing growing sensitivity to differences in macro-economic risks. These differences may soon be further aggravated by monetary policies from the major central banks that are about to diverge noticeably.
Copyright (c) Hussmsan Funds
Tags: Backdrops, Bank Of England, Core Rate Of Inflation, Credit Crisis, ECB, Economic Performance, Economic Recovery, Fed Chairman Bernanke, Financial Stability, Global Economies, Global Economy, Global Recovery, Global Stock Markets, Hester, Hussman Funds, Inflation Expectations, Inflation Rates, Rate Of Inflation, Stock Market Valuations, Stock Prices
Posted in Credit Markets, Markets | Comments Off
Thursday, February 17th, 2011
Food Chain: Do Spiking Food Prices Warn of Generalized Inflation?
February 14, 2011
- Food inflation heats up and incites global unrest.
- But for now, it’s unlikely to become a monetary phenomenon.
- Investors should expect geopolitical risk to stay elevated in 2011, with implications for emerging markets performance.
Inflation is back as a big concern … for some it never waned. The subject has headlined many of my reports during the past couple of years; since the Federal Reserve began pumping unprecedented sums of liquidity into the financial system in 2008.
Recently, it’s the shocking spike in food and, to a lesser degree, energy prices that has elevated the worries again that “core” (excluding food and energy) inflation will follow.
The recent troubling spike in food inflation, seen in the chart below, has its roots in major supply disruptions caused by extreme weather conditions in many of the largest food producing countries. But it’s also a function of booming emerging economies and the rise of their consumer population.
Skyrocketing Food Prices
Click to enlarge
Source: Commodity Research Bureau (CRB) and FactSet, as of February 11, 2011.
Rapidly rising inflation can be toxic not only to economies, but to profit margins and stock market valuations, as well. It’s also becoming toxic to the social fabric in countries where food is a large portion of consumers’ expenditures, like in emerging Asia (see chart below).
Unless food and fuel prices begin to ease, there are implications for Asia’s debt outlook and also for leaders hoping to prevent another Egyptian-style uprising; which had at its roots unrest about food prices and unemployment.
Emerging Economies’ Food Consumption
Click to enlarge
Source: Wolfe Trahan & Co. Portfolio Strategy, as of February 14, 2011. Chart uses region average.
The United Nations estimates that countries spent at least $1 trillion on food imports last year, with the poorest nations paying about 20% more than in 2009. Asian governments are expected to increase subsidies and cut import taxes, with potential important fiscal implications. This is on top of the social instability risks that the world watched in Egypt during the past several weeks.
Unlike the commodity price spike in 2008, that had a large speculative component to it, this one appears to be less cyclical and more secular. Asia’s diet is becoming more Western, with a greater focus on dairy and livestock, and less focus on its historic staples.
Rising commodity prices are making it difficult for China’s central bank in particular, but also in India and Indonesia, among others. Expect much tighter monetary policy in the region, which has implications for emerging markets performance. We continue to believe investors should not be overweight emerging markets relative to their strategic targets.
In fact, in addition to the fund flows coming out of bonds in reaction to the latest spike in Treasury yields, we think outflows from emerging markets could find their way to US stocks.
We do have some budding concern that there could be some upward pressure on core inflation in the United States, too, but think the implications of rising headline inflation will be felt more acutely in the emerging markets, both economically and socially.
Too much … too few
The late, great Milton Friedman once proclaimed that inflation is best defined as “too much money chasing too few goods.” Many are making the “too much money” argument because of the massive liquidity in the financial system. But that money remains stuck in the banking system, as we’ll discuss shortly.
Now it’s also the “too few goods” argument that is being made because of food shortages. But the real question for US monetary policy is whether the conditions are in place for general price inflation to take hold.
Given the tremendous amount of excess global capacity and limited upside wage pressures, core inflation risk in the developed world remains relatively benign.
The latest core inflation readings are:
- 0.8% in the United States (see chart below).
- 1.1% in the euro-zone.
- -0.7% in Japan.
- Even China’s core inflation, though higher than the aforementioned regions, is at a reasonable 2.1%.
Core Inflation in Check … For Now
Click to enlarge
Source: FactSet, as of December 31, 2010.
Many argue that it’s only a matter of time before core levels of inflation begin to heat up, given liquidity overflows. But Bank Credit Analyst (BCA) notes that developed world central banks have not been able to create a “money glut.” Money supply (M2) growth in the United States is up, but only 4.3% year-over-year. For the Organisation for Economic Co-operation and Development (OECD) as a whole, broad money is only growing at a 1.2% annual rate. An acceleration would likely put upward pressure on inflation expectations, so money supply growth rates need to be watched carefully.
More velocity needed
In reality, all that developed world central banks have accomplished is to free up reserves in their banking systems, little of which is getting passed through the lending channels to feed into the economy.
This is the concept of the “money multiplier” about which I’ve written extensively. The math behind what’s also called the “velocity” of money is dividing M2 money supply by the overall monetary base (currency in circulation plus banks’ required and excess deposits at the Fed).
When it’s low as it is presently, core inflation risk is benign. This is one of the key metrics we’re watching to see if inflation risk is increasing.
Velocity of Money on Floor
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Source: FactSet and Federal Reserve, as of February 4, 2011.
No wage-price spiral in sight
Another precondition for core inflation to erupt is excess wage growth and/or rising unit labor costs. This is the so-called “wage-price spiral” inflation that characterized the late 1970s and early 1980s. As you can see below, neither is highlighting trouble on the horizon.
Muted Wage Pressures
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Source: Department of Labor and FactSet, as of December 31, 2010.
No Unit Labor Cost Pressures
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Source: Department of Labor and FactSet, as of December 31, 2010.
As BCA points out, wage growth exceeding labor productivity is what triggered the wage-price spiral in the 1970s. In the mid-1970s, the difference between the two was 18%, while today it is barely in positive territory (up from negative territory in 2009).
The tax effect
Let me state the obvious by noting that rising food and energy prices do have an economic impact as they act as a tax on the consumer, which drains discretionary spending power. But as long as wage and unit labor cost growth is in check, there is unlikely to be widespread ability to pass along rising input costs to the end consumer. Rising commodity prices can’t create pricing power where it didn’t exist before.
That doesn’t mean there aren’t certain companies and/or industries that are having some success and this bears careful watching. The National Federation of Independent Business survey of small business price plans increased to 19% in January versus its recession low of 0% (it was 30% in 2007).
The airlines also announced price increases last week, along with a couple of large consumer products companies. Finally, University of Michigan’s survey of consumer inflation expectations rose to 4.5% in the first half of February versus its recession low of 1.7%.
What would trigger general price inflation?
We are starting to see an increase in bank lending, both for commercial and industrial (C&I) and consumer loans. A more sustained increase would cause the velocity of money to begin accelerating. Frankly, this is a necessity for a sustainable economic expansion, but it would also increase core inflation risk.
In addition, because emerging markets are behind much of the spike in commodity prices, it puts pressure on goods’ prices that are transported across borders. Clearly, producers of these goods have incentive to sell into inflating markets, so prices received are higher.
They will likely only sell to US dollar-based consumers if the US dollar price received is commensurate with the price in the inflating emerging markets. This could result in shortages, exacerbated by rumored hoarding, which would mean higher prices absent an increase in the velocity of money.
The hope is that the size dominance of the developed consumer markets versus the emerging consumer markets will prevent sufficient goods to flow to high-inflation markets to significantly increase generalized inflation risks globally.
The China Syndrome
China is at the heart of the inflation scare and bears close monitoring. Given its robust economic growth and excessive credit growth, the risk of food inflation passing through to general price levels is high and rising. It is somewhat tempered by monetary policy tightening and the fall in China’s leading economic indicators in reaction.
As BCA notes, if history is any guide, inflationary pressures could crest sooner than later alongside a slowing economy. China’s wage growth is about 16% year-over-year, roughly in line with productivity growth in the modern sector. This is the principal reason why core inflation has stayed low.
Fed reaction function
Traditional monetary inflation is not yet spreading in the global economy with limited wage growth not only in the Untied States, but in the G7 more broadly. And G7 productivity growth remains healthy. This should keep developed country central banks largely accommodative.
We do worry the Fed will remain accommodative too long though. As we’ve noted, we believe the US economy is well past the emergency phase that pushed the Fed to lower short rates to zero.
Expect the criticisms about too-easy monetary policy to persist with every uptick in commodity prices. Cries of the Fed being “behind the curve” will likely get a volume boost this year.
In the shorter term, it’s likely the social and economic implications of what we’re seeing with commodity prices that will continue to be the big story.
The information provided here is for general informational purposes only and should not be considered an individualized recommendation or personalized investment advice. The investment strategies mentioned here may not be suitable for everyone. Each investor needs to review an investment strategy for his or her own particular situation before making any investment decision.
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.
Examples provided are for illustrative (or “informational”) purposes only and not intended to be reflective of results you can expect to achieve.
Tags: BRIC, BRICs, Charles Schwab, Chief Investment Strategist, China, Commodity Research Bureau, Consumer Population, Crb, Currency, Egyptian Style, Emerging Asia, Emerging Economies, Emerging Markets, energy, Energy Prices, Extreme Weather Conditions, Factset, Food And Fuel, Food Consumption, Food prices, India, Liz Ann, Portfolio Strategy, Senior Vice President, Social Fabric, Stock Market Valuations, Trahan
Posted in Credit Markets, Emerging Markets, India, Markets, Outlook | Comments Off
Wednesday, February 9th, 2011
How the Junk Bond Bubble Supports Rising Equity Prices
by Michael ‘Mish’ Shedlock
Yesterday, I was asked about statements I have made on numerous occasions that the recovery of the junk bond market helps explain the rise in equity markets. Here is the specific question:
“Can you explain why you frequently say that the corporate bond market supports the equities market? I don’t see why it would have the major effect you seem to claim it does.”
Let’s go over the reasons once again.
- Companies that cannot get financing go out of business.
- In March of 2009 many corporations poised to go under because they could not get financing had exceptionally low stock market valuations. Even GE was on that list. Those stocks rose many multiples after Bernanke managed to revive the junk bond market.
- When companies issue long-term debt at lower and lower yields, their interest expense drops.
- The entire atmosphere of chasing yields lower is a sign of increased speculation across the board. One should expect stock prices to at least be firm in such conditions.
Everything changed when Bernanke stabilized junk bonds. Interestingly, Bloomberg discussed this situation today in Top Stories.
Maturity Wall Crumbles as $482 Billion of Debt Refinanced
The wall of bonds and loans maturing through 2014 has crumbled by $482 billion, or 44 percent, since 2009, reducing the threat of defaults and allowing companies to bring riskier deals to market. The amount of debt due in the next four years dropped to $671 billion, from $1.2 trillion in 2009, according to JPMorgan Chase & Co.
Some $163 billion of bonds and loans come due in 2011 and 2012, or about 60 percent of the refinancing activity in 2010. Clear Channel Communications Inc. said it plans to sell $750 million of bonds to repay $500 million of short-term loans.
Stronger economic growth and the Federal Reserve´s decision to keep benchmark interest rates at almost zero, while pumping $600 billion into the financial system by purchasing Treasuries, have driven down yields and spurred demand for low-rated debt. That´s allowed companies to seek new borrowings with fewer provisions that protect investors.
“The wall of worry has been greatly reduced,” said Sabur Moini, the high-yield money manager at Los Angeles-based Payden & Rygel, who oversees about $2 billion of speculative-grade debt. “You’ve had a big rally for the last two years and that’s allowed companies and underwriters to be more aggressive.”
How much better can things get, especially with treasury yields soaring?
I believe junk bonds are priced for perfection and equities priced well beyond perfection.
As I have said many times, when this all matters is anyone’s guess.
Mike “Mish” Shedlock
Tags: Clear Channel, Clear Channel Communications, Clear Channel Communications Inc, Corporate Bond Market, Economic Growth, Federal Reserve, Interest Expense, Jpmorgan Chase, Junk Bond Market, Junk Bonds, Maturity, Michael Mish, Refinancing, Short Term Loans, Speculation, Stock Market Valuations, Stock Prices, Term Debt, Trillion
Posted in Markets | 1 Comment »
Monday, June 21st, 2010
This article is a guest contribution by John P. Hussman, Ph.D., Hussman Funds.
As we survey the current state of evidence from market and economic data, my greatest concern remains that we may be nearing a point that mathematicians call a “discontinuity.” With respect to the stock market, valuations remain uncomfortably rich, and market action is tenuous. As I noted last week, “Keep in mind that after a clear break of major support levels, markets often recover back to that previous support, which can create a feeling of ‘all clear’ complacency. Be careful.”
Having largely cleared the recent oversold condition of the market, we are at an important inflection point. A further recovery in market action would most likely create modest further demand from already well-invested speculators and trend followers, and modest offsetting supply from already defensive value-oriented investors, allowing a dull but moderate continuation of upside progress. On the other hand, a deterioration in market action would likely trigger a substantial amount of liquidation by speculators, into a market where fundamentally-oriented investors would require large price adjustments in order to absorb it. That outcome could result in a price discontinuity.
As I’ve noted before, if something induces one trader to sell, the market must move in a way that either removes that impulse, or induces another trader to buy. In equilibrium, there is no other possibility. When an overvalued market loses support from market internals, it frequently produces discontinuous outcomes ranging from brief “air pockets” to “panics” to “crashes.” Emphatically, I am not forecasting or predicting a discontinuity as the only possible outcome, but it is important to recognize that the risk is elevated.
If one thinks of the data as telling a story, the picture here would most decidedly be a cliffhanger – where our hero dangles from a steep precipice, clutching a rock of uncertain strength, and where the evidence is not clear about what outcome will prevail. One outcome is a continuity, and the other is an abrupt discontinuity. It’s possible that things will resolve sufficiently well, but we have to consider the possibility that they will not. I am not suggesting that readers and shareholders deviate from careful discipline or well-diversified investment plans. Instead, I am urging them to make sure that a significant market decline would not derail their financial security or future plans, or cause them to abandon their discipline after the fact – something that I’ve seen investors do far too frequently over the past decade. These considerations are particularly important for investors who will need to satisfy specific expenses (tuition, medical bills, home downpayments) within a short number of years.
Tags: Air Pockets, Cliffhanger, Commodities, Complacency, Continuation, Crashes, Current State, Dangles, Deterioration, Discontinuity, Economic Data, Equilibrium, Hussman Funds, Inflection Point, Market Internals, Panics, Precipice, Price Adjustments, Speculators, Stock Market Valuations, Trend Followers
Posted in Bonds, Commodities, Markets | Comments Off
Monday, April 5th, 2010
The US jobless report on Friday sparked a jump in Treasury bond yields, sending the yield on 10-year Notes to 3.95% – the highest level since June last year.
The yield on 10-year Treasuries is at long last catching up with the stronger underlying economy as measured by the GDP-weighted ISM PMI. Also, the Fed’s purchasing of $1.25 billion of mortgage-backed securities ended last week, resulting in artificially lower long rates coming to an end.
Additionally the US bond market is facing a crucial time this week, with $82 billion in government bond auctions that could push yields beyond their current 10-month highs. And pundits will, needless to say, also be cognizant of massive further issuance still lying ahead. (Click here for James Grant’s take on Treasury yields.)
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The short-term picture for the 10-year Treasury Note shows the yield having broken upwards through its 50- and 200 day moving averages and looking set to breach the top boundary of a symmetrical triangle.
Monthly data, going back to 1998, also convey an important message when considering the two momentum-type oscillators (ROC and MACD) at the bottom of the chart below. The ROC reversed course (crossing the zero line) in October last year for the first time since a buy signal was given at the beginning of 2007, thereby flashing a primary sell signal. The MACD provided a similar indication in June 2009.
Still on the topic of long-term data, actually all the way back to 1850, the graph below featured in a recent report by Pring Turner Capital Group asking: “Are you prepared for a secular bear market in bonds? Bond owners beware”. As shown, the yield is just below its secular down trendline and it would not take a large move in yields to mark the end of the almost 30-year secular decline. What will this do to the US’s debt burden, the economic recovery and stock market valuations?
Source: Pring Turner Capital Group
On the economic front, with the further reduction of inventories coming to a close the US could be in for rising inflation propelled by the US GDP-weighted PMI for prices and oil prices.
Source: Plexus Asset Management (based on data from I-Net Bridge).
Bond yields in mature markets are likely to rise further as the global GDP-weighted manufacturing PMI continues to indicate global economic expansion. Current indications are that the yield on the 10-year Note may increase another 25–50 basis points in the coming months. However, the rise in bond yields may be kept in check as uncertainties regarding the impact of the global unwinding of stimulatory measures increase.
The last words go to Richard Russell (Dow Theory Letters) who said: “As for the bond market, I think it’s looking far ahead to the time when it will be difficult to sell US debt. There’s going to be just too much US debt to sell. But why can’t the Fed just print the money, and with that ‘garbage money’ mop up the US debt? That would mean the US was monetizing its debt, which would be highly inflationary.
“The new Obama health-care will most likely add billions of dollars to the total national debt. Nobody any longer is laughing at the idea of the US reneging on its debts. It sounds outlandish, but ‘escapes’ tend to change with the times. Now, for the first time, we hear talk of lowering the debt rating of US Treasury bonds. This would be a disaster. To sum it up, I believe the great bond bull market (1980 to 2010) has ended and that we’re now entering a great bear market in bonds.”
One could short US long bonds in a number of ways by means of ETFs, for example buying the ProShares Short Barclays Capital 20+ Year US Treasury Index ETF (TBF) or, for those more aggressively minded, the leveraged (2x) ProShares UltraShort 20+ Year Treasury Bond ETF (TBT).
[AA]For consideration by Canadian investors – Horizons BetaPro US 30-year Treasury Bull (HTU.to) or Horizons BetaPro US 30-year Treasury Bear (HTD.to) [AA]
A full list of these ETFs is provided here by Stock-Encyclopedia.com. On a tactical implementation note, given the strong rise in yields over the past two weeks, it is advisable to build the position in increments whenever yields show declines.
Source: MarketBeat, March 26, 2010.
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Tags: 10 Year Treasury, Bond Auctions, Bond Owners, Capital Group, Debt Burden, ETF, ETFs, Government Bond, James Grant, Macd, Mortgage Backed Securities, Moving Averages, Pring, Reversed Course, Secular Bear Market, Secular Decline, Stock Market Valuations, Symmetrical Triangle, Target, Treasury Bond Yields, Treasury Yields, Trendline, Us Bond Market, Year Treasury Note, Zero Line
Posted in Energy & Natural Resources, ETFs, Markets | Comments Off