Rosenberg On How Only The 10 Year Can Break The Market's Trendline And What Can Dent Top-Line Corporate Growth
Comparisons to last year's market performance continue coming from left and right. Today, David Rosenberg looks not only at the broken trendline from late last summer, when the market's decline was only arrested with the seemingly unnecessary QE2 (not to mention massive fiscal stimulus into year end) - well, if it was not needed why was it implemented, and why is it still running? Because the market, pardon economy, will crack at the first hint of excess liquidity tapering, forget removal. What should market strategists look for to see if we get a repeat of last spring's market topping action? Simple: the 10 Year (and real inflation)- "If we do go to 4% on the 10-year Treasury note on the back of higher
inflation expectations, then rest assured the broad expectation will be
that it is headed next to 4.5% and it will be interesting to see how the
equity market would respond to that prospect." We conclude by looking at why top-line corporate growth, largely driven by foreign growth, is due for a decline.
THE TREND IS YOUR FRIEND — UNTIL IT IS BROKEN
As Doug Kass most eloquently put it, a trend is special because it doesn’t break on its own. Some countervailing force, exogenous shock or surprise has to act as the inflection point — in both directions. Last year in the fall, when the stock market was about to break down to a new range but the trend was broken by the quasi announcement of QE2, followed by the substantial fiscal stimulus that bought time for another year. So what happened was that the ‘double dip’ concerns undermining market sentiment were reversed and a new trend of positive sustainable growth has re-emerged. While we are likely to see the economy slow down in the coming quarters, there is nothing we can see to suggest a contraction in GDP is forthcoming that quickly. So recession odds have been increasingly taken off the table, though the policy vacuum is likely to cause more than just an air pocket for the economy in 2012 (and recessions have this nasty historical tendency of taking place during election years). This market has managed to climb despite many a wall of worry and it has withstood the tests to date.
The S&P 500 was wobbling and seemingly on its way to a new and lower range just prior to the QE2 announcement from Mr. Bernanke last August — and the QE2 was a catalyst that helped break the downtrend. The improvement in the data and the added fiscal thrust have nurtured this new uptrend too. But what could happen to force a break in the other direction? After all, if you go back to the interim peak of last year, which took hold in late April, there was something that broke the uptrend and it had nothing to do with double-dip recession risks that came much later. It was when the yield on the 10-year note broke to 4% in early April of 2010 and provided some competition for the stock market that we started to see equities embark on a new downward trend for the next 3-4 months.
Well, you don’t have to be a chartist to see that we do have a breakout in the 10-year U.S. Treasury-note yield on our hands and before we go any further, the answer is no, we have not all of a sudden become inflation-phobes or bond bears. Far from it. But the prospect of an inflation scare and more upward pressure on yields over the near-term is the one development few people are talking about that could upset the apple cart.
The runup in yields so far, from the October lows, has been just about four parts “real rate” driven and one part “inflation” driven. The real rate adjustment reflects the improvement we have seen in the real economy as well as heightened risk appetite among investors. But we have had, nonetheless, a situation where food costs have surged at a 60% annual rate since last Fall and energy prices at a 45% annual rate. Considering that food and fuels make up 23% of the CPI, it would stand to reason that we are going to be seeing some pretty big headline numbers coming soon, even if the grocery chains come close to fully passing these costs to consumers. As we said yesterday, 4% headline inflation is when the stock market buckles for good, and based on our models and spreadsheets if this were to happen, it wouldn’t be until the very end of the year.
The key also will be the core because the markets have not had to contend with a +0.3% print since July 2008, which for many of us was a lifetime ago. This would be a surprise, and yet the last time we had commodities rising as sharply as they are today, we had a handful of them of 0.3% prints. If we do go to 4% on the 10-year Treasury note on the back of higher inflation expectations, then rest assured the broad expectation will be that it is headed next to 4.5% and it will be interesting to see how the equity market would respond to that prospect.
This is what is different today from a year ago — the surge in raw material prices. There are lags in terms of impact through the real economy, pricing and margins. The reason why we cannot rule out +0.3% for the core CPI or perhaps even a couple of nasty, even if brief reports, is that airlines are passing on the fuel costs and we know that apparel retailers will soon pass on the cotton-induced price increases. Moreover, unlike a year ago, the rental components of the CPI are no longer decelerating. This does pose a bit of a near-term problem because the best leading indicator of core goods CPI is the core intermediate PPI and it has risen now by 0.3% or more for four months in a row and at an annual rate of around 6%.
Imagine what printing a couple of 0.3%’s on core CPI in coming months will do to QE3 prospects — seriously damage them is what — at a time when 40% of market participants already believe that this is baked in the cake.
As an aside, consumer discretionary, financials, and utilities within the equity sectors would be the ones most negatively affected by the scenario depicted above; energy, technology, and materials are the areas that would have the lowest correlation with a near-term inflation and market interest rate spasm.
And Rosie on the end in top-line growth.
LOOKING AT SALES, NOT JUST EARNINGS
We are hearing how great S&P 500 sales are doing so far for Q4 — up 7.7% and beating estimates by the highest margin in a half-decade. We scoured the data as best we could and found that almost all the growth in sales is coming from outside the U.S.A. where revenues are growing at barely a 3% annual rate. The pace is around 20% for foreign-derived sources. So the question is what happens to revenues if the foreign stuff comes under some downward pressure in view of the policy tightening in most emerging markets and the fiscal tourniquet being applied through most of Europe.
The two reasons why companies have had such success in driving their profit growth into a V-shaped recovery has been via an exceptionally robust foreign sales performance and relentless cost-cutting. But you can’t cut costs forever and we are already seeing signs that the downward momentum in unit labour costs is subsiding. On top of that is the surge in material costs, which we have not seen percolate yet, but will surely compress margins from their current five-decade highs.
We should start to get some corporate guidance numbers next week but for the time being we do have the analyst upgrade-downgrade ratios, which has stagnated recently. They are no longer going up and are actually going down in six of the ten sectors. Those with positive momentum include technology and materials. Utilities and consumer discretionary are not screening well at all.
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