The defining feature of the present market and economic environment is incompatibility, juxtaposing weakness in emerging markets, materials, and inflation-protected securities with strength in equities and the U.S. dollar, a spike in interest rates, and an unusually steep yield curve in Treasury securities. The underlying thesis here couples a theme of deflation with a theme of robust economic strength. Taken together, the financial markets have priced a wide range of assets on the assumption that the U.S. is on the verge of a deflationary boom. Most likely, part of this scenario is wrong.
On Friday, bonds fell, stocks rallied and the U.S. dollar surged on strength in the June non-farm payroll report. While employment is widely understood to be a lagging, not leading indicator of the economy, the report would be worthy of enthusiasm if it was also coupled with strength in leading economic measures and coincident/lagging measures. We observe little evidence of that at present. Indeed, while both the establishment and household surveys showed job growth in June, the composition detail in the household survey was hardly an indication of a robust economy, with a loss of 240,000 full-time jobs offset by a 360,000 gain in employees reporting that they usually work part-time. Fully 352,000 of this increase fell into the category of “part time for economic reasons (slack work or business conditions).”
We can make sense of the “deflationary boom” thesis only if we consider various pieces in isolation, rather than as a cohesive whole. With Europe still in a recession, and an acute relapse of credit concerns in Portugal in recent days, Mario Draghi at the European Central Bank reached for the only tool still at his infinite disposal – words – to promise that interest rates would be held at zero for a significant length of time. In China, debt servicing problems are emerging in corporate and local government debt following years of unproductive overinvestment in still-vacant buildings, and attempts to slow the rapid, low-quality credit growth has quickly been met by strains on liquidity and economic growth. Coupled with the better-than-expected employment numbers, at least on the surface, Wall Street has chosen China and Europe to make the deflation case, and the perception of U.S. economic growth as the basis for a “cleanest dirty shirt” argument for the U.S. dollar and U.S. equities. In effect, Wall Street is singing “We are the world… so the rest of the world can sink into the sea.”
While the “deflationary boom” thesis appears implausible, our investment views don’t rest on that judgment. Rather, our investment views are driven by prevailing, observable conditions, and the average return/risk profile that has historically accompanied similar conditions. From that standpoint, the present difference between 10-year Treasury yields and 3-month T-bill yields is now higher than in 85% of post-war instances, with no evident pressures on inflation or capacity. While we fully expect a “tapering” of the pace of quantitative easing, we also estimate that even a 0.25% hike in Treasury bill yields would require the Federal Reserve to actually reduce the size of its balance sheet by at least $400 billion, which is nowhere in the offing. Even in the absence of recession risks (which we continue to view as a much greater prospect than a surprising economic boom), Treasury bonds appear reasonably priced relative to alternatives – something that we don’t believe can be said of equities.
We continue to expect significant pressures on corporate profit margins in the next several years, and with negative earnings pre-announcements outpacing positive ones by a 7-to-1 margin, the upcoming earnings season strikes us as a likely headwind for stocks. The prospect of Federal Reserve tapering is really only relevant in a psychological sense, as the Fed has pushed the monetary base to more than 20 cents per dollar of nominal GDP, and that figure would have to be cut back dramatically to support even the first hike in interest rates by the Fed. Indeed, my view is that while QE has distorted the financial markets, the Fed’s policies have no transmission to the U.S. economy, and despite the grand scale of Fed actions, the benefits have been limited to slight bursts of economic activity for a few months at a time. The pathological attention to the Fed has more to do with superstition than evidence (seeFollowing the Fed to 50% Flopsfor more detail on this front).
When we analyze the financial crisis and subsequent recovery, the key events are actually very clear. In March 2009, the Financial Accounting Standards Boardbowed to political pressureand removed “mark-to-market” accounting requirements, loosening U.S. accounting rules to allow banks to use “significant judgment” in how they valued the distressed assets on their books, and making it possible for them to avoid insolvency even if they were in fact insolvent. Since then, banks have largely refused to restructure mortgages and other loans, and the Federal Reserve’s zero-interest rate policies have allowed banks to gradually recapitalize themselves on the backs of savers earning zero-interest and homeowners locked into higher-interest mortgages. Many of these banks should instead have been restructured, at no loss to depositors, and with bank bondholders bearing the cost.
The Fed did not save the economy. Rather, the Financial Accounting Standards Board rescued the banks by making their accounting more opaque. The Fed’s policies then shifted the costs of financial recklessness onto those who are not financially reckless – particularly ordinary savers and the elderly on fixed incomes, while the economy has more or less floundered. The Fed’s policies aren’t to be hailed as virtuous efforts that saved the economy – they are more appropriately reviled as unethical policies that subordinate Main Street to Wall Street.
Regardless, Fed policy is what it is, and it is more productive to accurately estimate its effects and respond accordingly. On that front, even during the most recent market cycle, the general hierarchy of considerations has remained intact, in that market internals and trend-following considerations have outweighed monetary ones – on average – when the two have been in conflict. While overvalued, overbought, overbullish syndromes have historically outweighed both trend-sensitive and monetary factors, my impression is that the relative ineffectiveness during the past 18 months or so is an artifact of a mature, half-finished cycle still near its highs, and that investors will wish they had paid more attention to these factors (and the wicked losses that followed historical counterparts) by the time the present cycle is complete.
Meanwhile, last week’s market action did little to repair the broad internal dispersion that we’re observing in breadth, leadership, interest-sensitive groups, and materials, for example. Historically, drawdown risk tends to be deeper when overvalued, overbought, overbullish conditions are followed first by a breakdown in interest-sensitive sectors (seeMarket Internals Suggest a Shift to Risk Aversion). For now, these conditions continue to predominate and hold us to a defensive view in stocks.
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