No more copy paste from the world's biggest bond deflationist. A day after the NYT announced it will soon see its traffic plunge courtesy of a paywall, David Rosenberg says he is going the premium route as well. "Since first publishing Breakfast with Dave when I started with Gluskin Sheff + Associates back in May 2009, we had always notified our readership that the report was going to be made available on a free trial basis. For clients of our firm, the report is still going to be made available for free. But for non-clients, the free trial period will finish by the end of March. At that time, the Breakfast (and other meals) with Dave will become a paid subscription service with an annual fee of CAD $1,000." Sad - no more copy paste from one of the smarter macroeconomists out there.
More from Rosenberg
We will be providing more details as the time approaches. If you do plan on subscribing, we want you to know that the Breakfast with Dave research reports will look exactly the same but for security reasons will be using a secure PDF format. This new security will require a FileOpen software “plug-in” to be installed on your computer, and as part of the security process all subscribers will require a personal registration file from Gluskin Sheff to be able to open and read my Breakfast with Dave reports.
Watch for more news on these changes in my upcoming reports.
And some parting big picture observations from the Gluskin Sheff strategist which unfortunately going forward will be far scarcer. Nothing relaly new here, but a good summary nonetheless. At issue is Rosie's core argument that there will be no QE3. Needless to say, we disagree. If there is anything the BOJ reaction to the Earthquake has taught us is when faced with no other choice banks will dump up to half a trillion dollars in the markets to stabilize asset prices. As the market is only where it is due to the perceived endless support by the Fed there will be a bloodbath until such time as Bernanke promises to never let the market fall all over again. As such, the deflationist thesis the permeates Rosie's argument is to be debated.
HAS THE GAME CHANGED?
An object at rest will remain at rest unless acted on by an unbalanced force. An object in motion continues in motion with the same speed and in the same direction unless acted upon by an unbalanced force. This is otherwise known as Newton’s first law of motion.
In market parlance, this implies that a trend remains in force until such time as an exogenous shock causes it to either stall or reverse. Economic, geopolitical, and natural disaster events aside, equity markets around the world have definitely broken their intermediate-term uptrend. Combining all of the developments that have taken place, we are faced with a very confusing investing environment, so it is currently a completely appropriate time to keep a very close eye on the technical conditions in the various asset classes. It seems clear that from a technical perspective, the uptrend that began in early July has come to an end. As the legendary technical analyst Walter Murphy always said, the most important tool in technical analysis is the ruler and the pencil. The minimum retracement expectation of the July–February rally would be 0.382 or 1,217 on the S&P 500. The more common 0.618 retracement would suggest a move to slightly below 1,140.
The February top occurred at an important technical resistance level and included extreme bullish sentiment readings and extremely overbought momentum. Similar trend changes followed sentiment extremes in bonds, commodities, and currencies. The question on everyone’s mind is how far the most recent trend will go. It seems likely that at the next inflection point, few will be willing to recommend ‘buying the dip’ as they did yesterday morning.
At issue is whether this is a warning crack we are now experiencing or the beginning of the next cyclical bear market trend. Even if it is a warning crack or a corrective phase, recall that these reversals from massively overbought price levels can often sow the seeds of a sizeable market decline, as we saw in the fall of 1987, the winter of 1994, the summer of 1998, the winter of 2002, or the spring of 2010. To invoke Bob Farrell’s Rule 4: “Exponential rapidly rising or falling markets usually go further than you think, but they do not correct by going sideways”.
Since the summertime lows, the equity markets globally have looked rather parabolic (not to mention the 100% move in the past 24 months). At some point, a market priced for perfection was going to face an imperfection; the question was timing, from what level, and the nature of the event or events that would serve as the catalyst.
In the very near-term, the key issue is the extent to which Japan faces a nuclear meltdown, which would be an unmitigated disaster. This is the real unknown investors face, but what is known is that all the comparisons to Chernobyl, Kobe, 9-11, and Katrina are all off base. Yes they created temporary bouts of heightened risk premia, but global production links were not affected. The area that has been affected now contains a larger swath of industrial activity, which in turn will exert more effects on global growth than meets the eye (Japan has already shuttered 11 nuclear reactors with total capacity of 9.7 gigawatts, according to the NYT).
We also have to be braced for the possibility of an impasse — what happens if/when Japan’s tragedy subsides? The answer: the troubles in the Middle East will make their way back to page one. The tensions are flaring again, not so much in Libya but in Bahrain where the crisis has taken on a violent tone, reigniting Sunni-Shiite tensions (the government has declared a state of emergency, prior to Japan’s nuclear disaster, this would have been front page news in the FT instead of being buried on page 8). And this is where the rubber could meet the road in terms of influencing the next big move in the oil price.
Let’s take a step back for a second and recall that the recent peak in the equity market was not accompanied by the normal divergences that technical analysts like to see when calling for a reversal at the cyclical highs. Be that as it may, the magnitude of the economic, geopolitical and natural events that have occurred ince the peaks could theoretically provide a substitute for those divergences. Nevertheless, one must assume that the old Wall Street adage of ‘buying on the cannons and selling on the trumpets’ is going to be a factor if and when containment in Japan occurs and/or the threat of oil supply disruption in the Middle East moderates.
While it is important to remember that the rally from trough to peak after 9/11 was almost 25% and that it occurred in the middle of a bear market cycle, history doesn’t always repeat. And for some reasons, there still seems to be a general consensus that a nice buying opportunity awaits. While the stock market has cheapened, what has not changed all that much is the very high levels of bullishness in various market surveys. For example, Investors Intelligence flags a 52.2% share of bulls in its poll, versus a mere 22.3% in the bearish camp. At the end of August, just as it seemed as though the market was about to break down ahead of Mr. Bernanke’s strong verbal QE2 hint, the Investor Intelligence polls showed there to be 29.4% bulls and 37.7% bears. Now that is the sort of bearbull gap that multi-month rallies are typically built on.
Moving on to the fundamental outlook, evidence is mounting that the economy and corporate earnings are losing precious momentum. First quarter U.S. GDP estimates are being cut, and this followed the government’s own downward assessments of how the economy closed out 2010.
In addition to the direct economic impacts that can be expected from the Japan crisis, there are ripple effects to consider as well. As one example, Japanese parts are critical in the making an iPhone production process. And as the FT’s Gillian Tett aptly points out, 30% of global flash memory and 15% of D-Ram memory (for PCs) are made in Japan. Japanese companies produce roughly 20% of global semi-conductors and represent 40% of total electronic components. According to Bloomberg BusinessWeek Sony alone accounts for 10% of world production of laptop computer batteries. Distruptions to the global supply chain, especially in the global technology sphere, should not be underestimated.
Then there is the auto sector to consider, not to mention how Japan is such an important hub for the rest of Asia. Everybody seems to think that any knock-on effects on global supply chains will be “limited”, as Ms. Tett concludes. These are likely the same analysts that told us how “contained” the U.S. housing turndown would be. Let’s just remember that Japan is the third largest economy in the world and economists in their static framework who only see 0.1-0.2% of global growth impact typically do not take the spin-off impacts sufficiently into account.
Meanwhile, for all the talk of a visible recovery in the U.S.A., it is far less apparent to me. Stateside, consumer spending has been choppy and generally a disappointment in view of the recently-unveiled payroll tax cut. Capital spending plans are not going up as many economists had been expecting and there has been a notable deceleration in core capex orders and shipments in recent months. Even with two months of hefty increases in auto assemblies, the trend in U.S. industrial production and manufacturing activity, while positive, is now descending.
At a minimum, one must wonder how much of a dent we are going to see in the $60 billion of exports that are shipped to Japan annually, let alone the spill-over effects on the $270 billion that is sold to the rest of Asia, much of which is in the industrial space. The downdraft in housing activity is palpable. And this is all occurring in a fiscal spending cloud — a backdrop of surprising progress towards budget balancing at both the state, local and federal levels, which is necessary but growth-dampening.
In addition, whatever the rhetorical or actual benefit the economy experienced from QE2, it appears that any additional monetary stimulus beyond June is debatable, to say the least. With headline inflation on the rise, pumping more liquidity into the financial system even amidst a declining stock market is going to be a tough sell to many Fed Bank presidents and much of Congress too. At the root of the argument, it is becoming more difficult to identify what the tangible effects really were under the bond buying program, beyond a spurt of commodity and stock market inflation.
It pays to note that the peak in the equity market was made on February 18; three weeks after the initial problems in the Middle East and North Africa erupted. The decline persisted even after oil prices peaked in early March and well before the tragedy in Japan. That is important to know. As a result, I think it would be totally appropriate to consider that immediately prior to my recent absence (I was tending to my ailing mother who just passed away), I had been stressing that the outlook for capital expenditures, employment, consumer spending and profits was far more muddled than what was being penned in by the consensus. All of a sudden not only are GDP forecasts coming down after four months of being lifted, but earnings projections have also stopped rising over the past month.
Consumer confidence has taken a turn for the worse, initially because of sharply higher food and energy prices, but also because the boost in Q4 consumer spending was not really accompanied by an increase in organic income and there is really no sign of a reversal in the ongoing contraction of household credit. Gasoline prices in the U.S., already at their highest level since October 2008, are destined to reach $4 a gallon by Memorial Day — a level that will radically curb consumer discretionary spending. As it stands, one in three Americans polled in an RBC Capital Markets survey said they were already “significantly” altering their budgets due to higher gasoline prices.
While the University of Michigan consumer sentiment survey for March revealed a steep slide to 68.2 from 77.5 in February —- a five-month low — the sub-index for low-income households sank from 71.1 to 60.7. The last time it was this low was in March 2009 when the recession was at its worst. That says a lot regarding the success of QE2 and calls into question the Fed’s back-slapping over the economic landscape in the latest post-meeting press release. By playing a role in influencing commodity prices, especially essentials like food and fuels, it could be argued that QE2 produced some unintended consequences for the majority of folks who don’t allocate their discretionary budget based on what the stock market does.
Granted there has been an incentive-led burst of auto buying in recent months, but in reality, the majority of the credit growth in recent months can be found in student loans. It is worth noting that student loans are really the only type of loan you can get when you don’t have a job and need to pay for room and board. With real estate prices continuing to decline and credit card balances continuing to be charged off, a return to consumer balance sheet expansion is simply not in
Going back to the employment situation, I pointed out in early March that the most recent nonfarm payroll report, while interpreted as quite bullish by the masses, was really a disappointing post-January rebound that left the January- February average at +128k, little changed from the anaemic pace we had been seen since last fall. Yes, the unemployment rate has been falling thanks to the dwindling ranks of the labour force as those who had been receiving extended jobless benefits fall through the cracks — absent the decline in the participation rate this cycle, the unemployment rate would be sitting at 12% right now. Hence the slowing trend persists in nominal wages in addition to the outright contraction in work-based incomes in real terms.
While companies, in the aggregate, are no longer shedding labour, there is no evidence that either job openings or new hirings are taking hold. The latest Job Opening and Labor Turnover Survey (JOLTS) data for January showed that U.S. job openings dropped 161k, after a 45k decline in December, and now stand at their lowest level since July 2009 when the economy was barely emerging from the worst recession since the 1930s.
New hires also fell 193k and are now down in six of the past seven months — the lowest they have been since October 2009. The fact that layoffs fell 158k during the month offers little consolation but explains why jobless claims have been trending down at a much faster pace than net employment growth has been picking up. The labour market retains a soft underbelly for an economy soon to be heading into a third year of a post-recession recovery, and it is surprising to see the Fed refrain from reiterating this in the FOMC press statement — though perhaps the central bank is trying to send out an early signal that it is not going to be that quick to usher in QE3 once QE2 runs its course in June.
The problem for the Fed in terms of moving as quickly as June to extend quantitative easing is that we are going through a period of higher measured inflation rates. This is no longer December 2008 or August 2010 when deflation was a legitimate threat. That is clearly not the case now, at least as far as the Producer Price Index (PPI) and Consumer Price Index (CPI) statistics are concerned. We don’t expect to see a real inflation cycle taking hold until we either close the massive resource gap in the jobs market or until the next secular credit expansion takes hold, and that can be years away. But the surge in commodity prices — the Fed actually played a minor role here — is showing through definitively in the price statistics and several measures of inflation expectations are ticking up. Since the central bank has so often in the past talked about these measures it would seem inconsistent to ignore them in a bid to support asset prices once again.
Producer prices jumped in February, led by a 3.3% surge in energy prices and a 3.9% run-up in food. While the core index did only manage to rise 0.2%, pressures are building within the goods-producing sector. The core crude PPI, which measures producer prices at the early stages of production, have boomed at a 47% annual rate over the past three months. The core intermediate PPI, which represents the mid-part of the supply chain, have surged at a 10.9% annual rate. And then we have the core finished goods PPI up at a 4% annual rate, nearly double where it was when QE2 was first announced last August, and this will surely accelerate further as the lagged impact of the raw material price run-up percolates through the factory gate level.
Of course, we also just saw the February CPI data that came in moderately above expectations, with the headline up 0.5% MoM and the core up 0.2% but there is a creeping uptrend that is now in place and some energy pass-through is being recorded in airline fares, shipping rates, and delivery services. While bond yields have been declining on the back of a flight-to-safety bid as well as a growing realization that economic growth is more likely now to recede in coming months and quarters, inflation expectations are on the rise, at least for the time being. Interestingly enough, this may end up being more harmful to equities than to bonds because of the complications this poses for additional monetary stimulus and it has been this stimulus that has actually been a key driver of equity valuation at the expense of the bond market. This may sound counterintuitive, but what is driving bond yields lower now are not inflation expectations but lower real rates and lower investors risk appetite. We don’t expect the inflation bulge to last for long, but certainly long enough to push the Fed to the sidelines once QE2 runs its course. Again, not just the actual inflation data, but the 5-year breakeven levels from the TIPS market have risen more than 30 basis points since the end of 2010, and the University of Michigan 5-to- 10-year median inflation expectation index has broken out visibly to the upside, from 2.8% in December, to 2.9% in January and February, to 3.2% in March — the highest since August 2008.
In fact, the Fed tried to generate inflation but it got the wrong kind of inflation. It didn’t get wage inflation, which helps people in their spending plans. It didn’t generate real estate inflation even if it did ignite the stock market for a few months in any event. Instead, what we have are soaring prices for the items that are very difficult to substitute away from like energy and food — that’s the inflation we have.
Meanwhile, for all the talk of how great it is that the Fed has managed to cause inflation expectations to rise, what good is that for the marginal household. Maybe these pundits supporting the Fed on CNBC should run the correlations like we did — there is a well-defined historical inverse correlation between household inflation expectations and the direction of consumer confidence. So it wasn’t at all a mere coincidence that in the same month that inflation expectations shot up to near-two-year highs, consumer confidence, especially for the low-income strata, fell back to the depressionary levels posted back in the 2009 winter of discontent. Well done, Ben!
If we see some sort of resolution to the crisis in Japan, we should see a nice short-term bounce in the equity market. We are very close to seeing initial support levels kick in for the S&P 500, which would warrant a less negative stance. But any “good news” rally is likely to be brief because as I mentioned in the first paragraph, the trend lines have been broken this time around. Unlike last summer, a sizeable number of portfolio managers are positioned for another round of quantitative easing.
And in contrast to other past natural disasters like Katrina, there are numerous other obstacles, both in terms of geopolitics and the effects on the oil price, and sovereign debt levels and the ability for governments to re-stimulate, that will resurface once the Japanese situation stabilizes. Unlike other periods of natural disasters where initial selling turned into a great buying opportunity, the problem this time is that once Japan is off the front pages, spreading political unrest in the Arab world can be expected to take its place. The fact that Bahrain has declared a state of emergency is hardly encouraging, nor is the heightened violence in Libya.
Then of course we have the budget battle south of the border and the possibility of a U.S. government shutdown by April 8. With Portugal and Spain just being downgraded it is hardly the case that the European debt situation has been resolved. The European Central Bank, unlike the Fed, will respond to higher statistical inflation because that is its mandate, and it is already bracing the markets for an interest rate hike over the near-term. You don’t need to delve much into history to know that the last time the European Central Bank pulled such a pre-emptive stunt was back in the summer of 2008, it proved to be a huge policy misstep. And, of course, we have the prospect that the Fed does not embark on QE3 and a CNBC poll just showed that one-third of portfolio managers are positioned for an extension post-June —they may well be in for a big surprise. [ZH: or not]
In other words, the case for our hedge fund strategies is now very strong because market volatility is the one feature of the equity, debt, and resource markets that is not going to subside any time soon. The case for long-short relative value portfolios is stronger than it was at the start of the year when I thought it was very compelling, despite the challenges of 2010.
What about the bond market and the direction of yields?
There seems to be this widespread view that Treasury yields will rise sharply once QE2 is over and done with since the captive market for bonds — the Federal Reserve — will be on the sidelines.
Wrong. Wrong. Wrong.
The only way Treasury yields will rise is if we have an accelerating economy, rising credit demands, and heightened inflation risks.
If truth be told, QE1 and QE2 were not at all friendly to the Treasury market. In both cases, after an initial rush, bond yields rose sharply even with the Fed’s bond buying activity — by 180bps in the former and 130bps during the latter. The reason for this is (i) the Fed is really trying to pump risk assets and (ii) reflate the economy.
It is interesting that the best days for the Treasury market in 2010 were in the April-August period when the yield on the 10-year note dropped 160 basis points, even with the Federal Reserve keeping its holdings of Treasury bonds and notes stuck at $712 billion (after buying $260 billion worth in the prior year). The question becomes — who were the buyers? After all, during that fivemonth span, federal bond issuance topped $500 billion. The answer: commercial banks, foreign central banks, pension funds, insurance companies, households, and mutual funds. In fact, what is interesting is that the return of the retail investor has been an important driver of lower bond yields in recent weeks. The ICI reported that in the week of March 9, net inflows into taxable bond funds totalled $3.9 billion. Maybe those worrying about who will buy the bonds once QE2 ends should spend more time assessing who is going to be the marginal buyer of equities, especially with portfolio cash ratios at historical lows and retail investors showing little appetite for risk. After briefly dipping their toes into the stock market late last year investors withdrew $1.22 billion from U.S. stock funds last week as an example.
True, the Fed has been financing practically the entire U.S. government deficit since QE2 commenced but even once the program ends the reinvestment of principal payments of mortgage securities back into Treasuries will be so large that this alone will still finance about one-third of Uncle Sam’s funding needs. And let’s not forget the Treasury market’s best friend — Japan. First, the Bank of Japan announced a Y21.8 trillion infusion of liquidity in response to cash needs stemming from the escalating crisis. A good part of that will surely make its way into the Treasury market as liquidity preference intensifies. And there is no way the central bank is going to sanction a stronger yen either so it is reasonable to assume the Bank of Japan will be stepping up its buying activity in U.S. Treasuries, as it has for years. In fact, since 2005, Japan has purchased $260
billion worth of Treasuries, with two-thirds of that coming in the last year alone.
We said above that it was tough to predict two weeks ago that Libya and Bahrain would be so easily pushed off the front pages of the morning papers. Then again, what is happening in Japan is a really big deal. And it was the events in the Middle East, after all, that pushed Europe off the front cover. The debt and solvency problems in the euro area have not gone away — not by a long shot.
Just days after Moody’s cut Spain’s credit rating, Portugal got cut by two notches and now has a ranking that is just four notches away from “junk”. It’s a miracle that the euro continues to trade near the 1.40 mark, but then again, the U.S. government itself is running on a stop-gap funding bill that runs out on April 8.
Finally, it is hard to believe, looking at the housing data and understanding the sector’s importance in driving growth for the entire economy given all the huge multiplier effects, that we can end up having much of a recovery during periods where there is scant government stimulus. Housing starts collapsed at an astounding 95% annual rate in February (yes, you read that correctly) to stand at 479k units at an annual rate, the second lowest on record and the lowest since the economy was plumbing the depths in April 2009. Normally, housing starts are up 34% from the time the recession ends to the 20th month of the expansion (where we are now) — not down 18% as is the case currently. In fact, never before have housing starts been negative at this point into a recovery, let alone being down a huge 18% since the recession ended.
For all the chatter about how typical a cycle this is, single-family starts sagged 9.3% after a 4.8% plunge in January so clearly the homebuilders are feeling the effects of sharply weaker demand. This is underscored by the fact that mortgage approvals for new home purchases slumped 4% last week to stand 16% lower than year-ago levels — and those year-ago levels themselves were down 14% from the year before that (March 2008). The fact that building permits, which lead starts, plunged 8.2% after that dramatic 10.2% falloff in January suggests that a turnaround is not yet in sight, sadly enough — at 517k units. They are also nearly back to the depression-like level of 522k in March 2009. Incredible, this is the most credit-sensitive sector in the economy and 80% of the time is responsible for the initial thrust of activity coming out of a downturn. Despite the recent retreat in mortgage rates and ever-improving affordability, housing activity continues to decline under the weight of what can still be described as a radical excess supply overhang, especially when the “shadow” foreclosure inventory is taken into account. Without a healthy housing market, and absent recurring doses of government stimulus, the whole recovery, in my opinion, remains extremely fragile.
A sharp slowing in global GDP in the second half of the year cannot be ruled out, and one should expect continued market volatility in coming months. This in turn means an equity investment focus on high-quality equities with strong balance sheets. A more defensive than cyclical approach through exposure to oil and precious metals are warranted, and a yield orientation along with emphasis on relative-value trades to hedge out and manage the risk within the portfolio.