CHINA OFFICIALLY TAKES SILVER WHILE THE US FLOUNDERS

For a second consecutive week, poor economic data created headwinds for the equity markets causing the S&P 500 Index to fall 0.7% and sending the Dow Jones Industrial Average down by 0.9%. 

 

The week began in positive fashion, but sellers overwhelmed buyers after initial jobless claims rose and a manufacturing survey from the Philadelphia Fed fell precipitously. 

 

At the start of the week, we learned that foreign demand for U.S. Treasury securities waned slightly from prior months.  Overseas investors purchased $33bln of Treasury notes and bonds in June, but China became a net seller to the tune of $24bln.  China remains slightly ahead of Japan as the largest holder of U.S. treasuries, with $844bln.  Japan holds $804bln.

 

That news was overshadowed by the announcement that Chinese gross domestic product (GDP) overtook Japan during the second quarter.  Nominal GDP in Japan registered $1.3trln in the quarter, slightly less than China’s $1.3trln.  The global media is enamored with the Chinese growth story, but in reality this should not be an enormous surprise. 

 

For much of the past 2000 years, India and China were the dominant economies on the global landscape.  Economic superpower status changed abruptly during the industrial revolution, but as The Economist pointed out, “Why they fell so far behind may be more of a mystery than why they are currently flourishing.”   

 

Source: The Economist

 

Returning to the domestic economy, there was almost nothing to elicit cheers last week.  Housing starts increased 1.7% in July, but that was due to a downward revision in the June figures.  With the government gradually disappearing from the housing market, we are learning, as expected, that demand is tepid at best.  The improvement, if one could really call it that, in July was purely a result of gains in the multi-family component which spiked 32.6%.  Single-family starts were off another 4.2%.

 

Source: Royal Bank of Canada

Consumers received another dose of mixed information from the Federal Reserve Bank of New York (FRBNY).  According to a new quarterly report from the FRBNY on the state of consumer finances, household debt totaled $11.7trln at the end of the second quarter, down 1.5% from March. 

 

Source: Federal Reserve Bank of New York

 

On the one hand, household debt is declining, which is an obvious plus.  On the other hand, bankruptcies are on the rise and forward momentum appears plentiful.  The FRBNY noted that $1.3trln of consumer debt was delinquent at the end of last quarter with another $986bln a minimum of 90 days past due.  With 11.4% of all outstanding debt in delinquency, the likelihood is that bankruptcies have nowhere to go but up.   

 

Source: The Economist

 

Somewhat more encouraging was news that lending standards are beginning to ease to both consumer and corporate borrowers.  Despite the softening standards, banks reported that demand remains relatively weak. 

 

Source: Board of Governors of the Federal Reserve

 

The recent string of disappointing economic news is weighing not only on the outlook of market strategists, but also on indices of leading indicators.  On average, strategists are now expecting the S&P to finish the year at 1,235 from the July expectation of 1,250.  That would represent a 13% appreciation from current prices.

 

Source: Bespoke Investment Group

 

On Thursday, the Conference Board reported that its Leading Economic Index (LEI) posted a 0.1% increase in July after falling 0.3% in June.  It was a small ray of light amidst the gloom last week and points towards continued economic expansion in the second half of the year, albeit at a distinctly sluggish pace. 

 

Source: Kansas City Star

 

In addition to the LEI, the Weekly Leading Index from the Economic Cycle Research Institute, which has garnered so much attention in recent weeks, is experiencing a slight recovery.  Alarmists were previously ringing the bell after the index dropped into negative territory as they felt it was a definite sign that a new recession was on the way.  With the index changing direction and heading back towards positive ground, it appears that this is unlikely.  If the index suddenly switches direction again, the probability of a recession is much higher. 

 

Source: Economic Cycle Research Institute

WHO IS TELLING THE TRUTH?

Over the past several months, bond and equity markets have been on starkly divergent paths.  Investors are growing increasingly concerned that perhaps the bond market knows something that the stock market is overlooking.  In reality, the answer may be simpler than we realize.

 

As of the middle of last week, Citi research discovered that global equities are up roughly 6% while global government bonds yields are down 25 basis points.  In the U.S., the situation is even more dramatic with yields down nearly 1.5% since the peak in late April.

 

Source: FT Alphaville

 

There are seemingly two explanations for the recent turn of events.  The first is corporations.  Corporate cash at nonfinancial companies is up 26% through March to $1.8trln, the largest such increase since at least 1952. 

 

Source: Wall Street Journal

 

Emerging from one of the most severe recessions in the last century, companies are more than willing to hoard cash and favor a  ‘wait and see’ approach before resuming expansion.   Cash levels at S&P 1500 companies are well in excess of $1trln now, but, where does that extra cash wind up? 

 

Source: Standard & Poor’s

 

According to a recent survey from CFO.com, 74% of short-term cash is placed in bank deposits, money market funds or U.S. Treasury securities. 

 

The second reason bond yields are falling is that individual investors continue to sell equities in favor of fixed income securities.  Through July, investors took $33bln out of domestic equity funds, with much of that finding a home in the perceived safety of taxable bonds. 

 

Source: NY Times

 

This is hardly the first time such an occurrence has happened.  In fact, Citi found a number of occasions since 2000 where global bond yields fell as global equities rallied.  In a majority of those instances, the equity markets were right.  Equities continued to rally and bond yields eventually rose.

 

Source: FT Alphaville

 

There is reason to believe that equities offer the more compelling opportunity going forward.  Forgetting the impact of price appreciation, the average dividend yield on the DJIA was 2.94% as on August 13th, compared to a current yield of 2.62% on the 10-year Treasury. 

 

Source: Economic Forecasts & Opinions

 

The last time the DJIA had a higher yield than the 10-year Treasury was in late 2008/early 2009.  It is relatively uncommon for the DJIA to exhibit a higher yield, although, in the early part of last century it was a common occurrence. 

 

Source: Bespoke Investment Group

 

The Treasury market has been susceptible to a number of technical factors in recent months, from the recent announcement by the Federal Reserve to purchase treasuries to huge individual investor inflows.  Yields could certainly fall further if the economy enters a second recession, but the likelihood of that is marginal at the moment.

THE WEEK AHEAD

It is a relatively quiet week with investors soaking up the last few rays of sunshine before summer comes to an end.

 

The government will auction $109bln of debt this week, including $7bln of 30-yr TIPS (Monday), $37bln of 2-yr notes (Tuesday), $36bln of 5-yr notes (Wednesday) and $29bln of 7-yr notes (Thursday).  

 

2nd quarter GDP is expected to be revised down from 2.4% to 1.4% on Friday.  The initial release was missing important pieces of data and economists now believe that inventory boost will be less than originally anticipated. 

 

Beginning on August 27th, the Federal Reserve Bank of Kansas City will hold its annual symposium in Jackson Hole, Wyoming.  Ben Bernanke will address the group on the first day. 

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