David Rosenberg On Perception Versus Reality
We have already broadly discussed the recent euphoria in the market which especially in the Nasdaq has hit 5 year+ extremes. And as always in times of such irrational exuberance, the disconnect between perception and reality is truly astounding. David Rosenberg presents his views on the latest developments in the market's ongoing fight with manic-depressive disorder.
PERCEPTION VERSUS REALITY
I have been a secular bond bull and am not yet changing my view of the fixed-income market, but the perception that the economy will grow vigorously is now extremely strong. The view that Europe will solve its problems is pervasive and that the emerging economies will propel global growth despite the need to tighten policy. I think that the U.S. economy will only grow about 2% next year and that core inflation will remain on a declining trend. I can see some European countries having to undergo a debt restructuring causing a rise in risk premia in general, but the reality is that this will likely take more time to play out than I had thought before. For the time being, I would expect upward revisions to Q4 and by extension Q1 2011 GDP and hence earnings; therefore, over the near-term, it may not be a bad idea, tactically, to lighten up on the bearishness.
As I mentioned above, I am not changing my view, but think of it as a company lifting the bottom end of its revenue forecast.
I continue to see these as primary downside risks, but again, likely not immediate threats:
- The U.S. Treasury market becomes unglued.
- Further sharp increases in energy prices.
- Renewed fiscal problems in Europe.
- Bad inflation news out of emerging markets.
- U.S. state & local cutbacks become more severe.
- Latest down-leg in home prices accelerates.
Let’s examine each one of these.
The U.S. Treasury market
The bond market has clearly overreacted to the so-called fiscal stimulus. This is a clear case of perception and reality going through a temporary separation. The market perceived this to be a stimulus, but all the government has done is to ensure that there is no federal withdrawal in 2011. Fine. This means that Treasury borrowings will be about the same next year as it was in 2010. As far as we can tell, the yield on the 10-year T-note ranged between 2.4% and 4.0% in 2010, so there is no reason to believe there will be a breakout from that range in the coming year.
That said, it is also true that every action has an equal and opposite reaction (thank you Sir Isaac Newton). The fact that Obama was so quick to ink a deal that included a hand in the Social Security cookie jar without even a sketch of a medium term fiscal plan to reduce the deficit has created a bit of a stir among some of the previously comatose bond vigilantes. There is some risk of added upward pressure in yields over the near-term, but it will not be sustained. And, as we saw last year, if the 10-year note yield approaches 4%, then we can expect the equity market to roll over. Recall that we have not seen the Tea Party in action yet — if you are long bonds, these folks are your friends. Stimulus is not on their vernacular. Moreover, wait until Ron Paul gets his hands on Bernanke (see the Sunday NYT business section for more) when he begins to lead the House panel’s domestic monetary policy subcommittee.
Economists are as busy raising their economic forecasts now with the stock market at a high as they were cutting them last July and August when the market was testing its lows for the year. There is a whiff of contrarianism in the air.
The fiscal package sounds pro-growth, but in fact it remains to be seen how much of the relief is going to be saved or spent — especially the payroll tax cut which, frankly, is very poor fiscal policy. It is no different than the attempt by President Bush to get the economy moving in the winter of 2008 with the massive tax rebates, which fell far short of ending the recession. There is tremendous econometric evidence, which strongly suggests that only tax cuts that are perceived to be permanent contribute to spending — people do not alter their behaviour based on changes to their income, wealth or job situation that are considered to be temporary. Temporary tax cuts, which the payroll reduction is, go into savings. This is where the economists who are aggressively boosting their forecasts — as they did in early 2008 — are likely to be wrong yet again.
So while the spending multiplier is likely to be as weak now as it was back in 2008, the impact of the jobless benefit extension will also be seen more in a further increase in the unemployment rate since these folks will be paid to be out of work at a time when the number of job openings has risen to a post-crisis high of 3.4 million. Moreover, providing stimulus to businesses in the form of accelerated depreciation allowances at a time when the nonfarm nonfinancial business sector is sitting on a $1.93 trillion cash hoard (7.4% of assets, the highest in 52 years) is a little nutty. At most, it is a waste of time and public resources. Go figure. The one thing that the market should realize is that this really is the last kick at the can at fiscal and monetary easing for at least the next two years.
The energy price run-up is no shock, but it is a drag on real growth. While oil prices would have to go back to their 2008 highs to offset the recent fiscal boost, the run-up towards $90/bbl has already done its damage. Gasoline prices at the pump are now over $3/gallon in 20 states and the surge has effectively drained $40 billion out of household cash flow. So, a good part of that Bush tax cut extension is going to be siphoned into the gas tank.
Renewed fiscal problems in Europe
The perception is that the U.S. economy will now grow strongly; that Europe will solve its problems and that emerging economies will continue to propel global growth. But the reality is that the U.S. economy is going nowhere without government life support. This remains an extremely fragile recovery with few organic underpinnings.
We believe that the U.S. economy will barely expand 2% next year and that deflation will remain the primary risk. Some European countries will default causing a sharp rise in risk premia — witness the sharp erosion in the Spanish bond market last week. Moody’s just said it is putting 10 Portuguese banks under review for possible downgrade. In the wake of the Fitch downgrade, Ireland’s CDS spreads (550bps) now trade above the Ukraine! And the Ukraine has a B rating, not BBB as Ireland still clings to, but not for long.
Meanwhile, the typical investor has totally taken his/her eye off the ball as it pertains to the prospect of a deflationary shock coming from the other side of the Atlantic. There is apparently a very heavy debt refinancing calendar in Europe in the first quarter of the new year and of course there is also the Irish election (have a look at Debt Refinancing Sparks Fears of Deeper Euro Crisis on page 3 of today’s FT). The eurozone has to refinance a record $750bln of debt in 2011, and this pressure is likely to force Portugal into the unenviable position in following Ireland and Greece on the road towards emergency funding. Headline risk from that part of the world promises to usher in a heightened period of volatility and safe-haven movements in various asset markets and currencies, which is why now is the time to buy insurance against a possible market correction, to expect a reversal in the bond yield run-up and flows into currencies like the U.S. dollar and the Swiss franc during the first quarter. But start planning now. There is no better signpost of what is to come than the litany of growth upgrades from the economics community, which is the hallmark of a market top.
The good news for the bond market actually comes from a survey cited on page 15 of the weekend FT — conducted by Knight Capital — which found that 54% of respondents believed the backup in yields was due to U.S. fiscal fears. These fears are unwarranted as far as what they mean for providing anything more than a brief lift to growth, and remember, this new Congress is going to be chock full of folks who are fiscal hawks and who also want to rein in a Federal Reserve that has likely gone way too far in pursuing its multiple mandates. Only 29% of the respondents see the increase in yields as having anything to do with inflation, and it was equally encouraging to see consumer inflation expectations recede a notch in last Friday’s University of Michigan Consumer Sentiment survey for December. Without inflation, any bond selloff will prove to be temporary, not to mention a great opportunity to add some more income to the portfolio.
As an aside, and we have mentioned this repeatedly, our long-standing SIRP theme is not exclusive to bonds, but also hybrids, royalties, MLPs, trusts, REITS and income-equity. After all, 299 U.S. companies in Q3 boosted their dividend payouts, up 56% from a year ago (just 35 companies cut, a 74% slide).
Bad inflation news out of emerging markets
Meanwhile, inflation is becoming more entrenched in the emerging market world — China’s CPI jumped 1.1% MOM in November, which was well above expected and pushed the headline YoY rate to a 48-month high of 5.1% (consensus was at 4.7%). The YoY trend in producer prices just spiked to 6.1% from 5.0% in October, and is nearly 2% now even after stripping food out. This comes right after the government raised banking sector reserve requirements for the third time in the past month; however, it is increasingly becoming obvious that more aggressive action is going to be required such as interest rate hikes and currency appreciation. The concerns that the PBOC is behind the inflation curve, and will have to clamp down that much more on growth, is singularly the most pronounced risk for the commodity price outlook for the coming year.
U.S. state & local government
With regard to state and local governments, the pressure is going to be more intense with respect to funding as the “Build America Bond” program draws to a close. Much of last year’s fiscal stimulus went into state government coffers and that source of assistance is now gone. The sector has laid off 250,000 people in the past year and more is to come as this crucial 13% chunk of the economy moves further into downside mode.
Latest down-leg in home prices accelerates
It’s perplexing that the latest down-leg in U.S. home prices has gone virtually unnoticed by the media and the markets. The Case-Shiller index is down in each of the past three months and there is still roughly two years’ of unsold inventory overhanging the market once the “shadow” foreclosure backlog is included.
Meanwhile, as we saw in the latest UofM consumer sentiment survey, demand is dormant as homebuying intentions slipped in December to a level that can only be described as anaemic. Mortgage applications remain near decade-low levels and part of this reflects lingering caution among private lenders who are still maintaining fairly stringent credit guidelines — have a look at Housing Shaky as Lenders Tighten on page A4 of the WSJ. Interesting enough, the banks are once again sending out credit cards en masse — perhaps because borrowers this cycle have ensured that they stay current on their plastic even as they fall behind on their mortgage payments — see Lenders Return to Big Mails on Credit Cards on the front page of today’s NYT.
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