A slew of traditionally interesting insights in today's piece by David Rosenberg. Probably the most interesting data point has to do with further evidence of what as we have been claiming for about two months now, is shaping up to be the "mother" of all margin squeezes. Rosie, always a bond bull, looks at recent moves in bond prices and is confident we may have gone through the capitulation phase. We, on the other hand, are not so sure the capitulation is done, and believe quite a bit more selling may be in stock, as increasing concerns of how the Fed will unwind its books now that pundits have you believe that the economy is improving. Keep in mind: when QE2 (and 2.1 if Jan Hatzius is correct) is done, the Fed will have well over $3.5 trillion in rate-sensitive instruments on their hands. Add this to the annual issuance of about $1.5-$2 trillion in gross debt issuance, and one can see why the supply-demand picture in bonds, far from being determined by economic fundamentals, will be very entertaining in the future.
Rosie on the PPI confirmation of a margin squeeze:
The U.S. PPI, at +0.8% MoM in November and the core (which removes the effects of food and energy) at +0.3%, were both above expected but skewed by a seasonal rebound in auto pricing. Outside of that, core would have been as expected at +0.2%.
What is striking, however, is how cost trends are accelerating at the early stages of production in lagged response to the recent leg of the commodity boom. The “core crude” PPI jumped 3.1% MoM and is now up 30.2% on a year-over-year basis. This is the very early pipeline stage.
At the same time, core intermediate PPI leapt 0.7% and is up 4.7% from a year ago. When we get to final core goods PPI, the YoY trend is running at a mere 1.2% (and -0.7% on a three-month annualized basis).
In other words, the closer you are to the commodity complex, businesses have greater pricing power. And, the closer you are to the consumer at the final stages of production, the less pricing power you have.
Chart 8 illustrates is that we have one “mother” of a margin squeeze on our hands (this is the ratio of final goods PPI to core crude PPI). What helped margins to widen and profits to surge was the ongoing efforts to squeeze labour costs out of the system. However, if the NFIB index showed us anything, it is that wage intentions are on the rise (see Chart 9). So, if we don’t see some further big productivity improvements or renewed attempts to curb labour costs, then we can expect to see profit margins recede and earnings estimates soon begin to roll over.
Bond Capitulation Over?
The 10-year Treasury yield is now approaching its most overbought level (according to its relative strength index) since the summer 2007 yield peak. Other similar overbought periods were at the August 2003 and May 2004 interim yield peaks. Yields declined dramatically from each of these overbought yield peaks and stocks took a break. Bond market sentiment is tied for record lows as well (consensus at 25% bulls) and today’s yield exceeded the 61.8% retracement level from the April yield peak around 4.01%, confirming that the October low of 2.4% was ‘the’ low for some time yet.
I’m kind of thinking that the secular bull market in bonds will be a basing period of rolling lows near the 2% level on the 10-year Treasury note yield. The December 2008 low was THE low; the recent October 2009 yield low was another important low, but at a higher level. So this does not rule out a nice rally in bonds once capitulation sets in. The stock market will be the arbiter as it was when the 10-year note yield hit 4% last April and the equity market turned in its interim high, which wasn’t pierced until a month later.
Recall that last year this time bond yields went up over 60bps trough to peak and the S&P 500 rallied 2% and closed at the highs for the year as 2009 drew to a close. This told us nothing about how 2010 would shape up, which was a year of volatility — a high in April followed by European-induced concerns in May and June, then double-dip concerns in July and August, to then be followed by euphoria amidst QE2, the mid-term elections, more fiscal stimulus and hedge-fund performance catch up. 2010 turned into a volatile meat-grinder and the year was saved for investors because of the extension of monetary and fiscal stimulus — there is a whole new Congress and a whole new set of voters on the Fed in 2011, so relying on more stimulus could be dangerous. In the interim, there are plenty of things to be worried about from European fiscal woes, to the upcoming U.S. debt ceiling file, to another leg down in housing prices, and to heightened inflation pressure in the emerging markets.
And, as always, some broader economic (and market or what's left of it) observations:
Europe remains a clear downside risk for the global economic outlook with the problems spreading to Spain and Portugal (the ECB is now planning to double the size of its capital cushion in response to the spreading sovereign and bank credit problems). Contagion risks are being underestimated by Mr. Market who has been myopically focused on irresponsible fiscal expansion in the U.S.A. and recent hopes that QE2 would morph into QE3. As some proof that the recent economic data flow are over-rated, and likely exaggerated by seasonal influences, the Fed barely raised its macro outlook and actually seemed to dampen its view of the housing sector.
As for Europe, numbers we saw today on Bloomberg showed that if Spanish banks ever have to undergo the capital raise that Ireland just went through, you would be talking about a recapitalization plan of €80-90 billion. And, what exactly happens to these banks if the article today on Bloomberg titled Spain’s Official Home Prices Don’t reflect Slump is anywhere close to the ball-park in forecasting another 20% slide in home prices on top of the 23% that has already occurred. The Europeans may need something bigger than a bazooka to deal with that (more like a Panzerschreck). In Ireland, the banks cannot fund themselves because market rates are in excess of 8% (at a time of deflating nominal GDP) and despite all the support, yield spreads off Germany are still 9x the historical norm.
Currency wars remain another key issue and we are hearing some market chatter that South Korea is considering implementing a round of taxes and levies to curb capital inflows. Chile’s central bank is also contemplating such moves to lean against the 15% appreciation in the peso since mid-2010. History shows that such overt currency intervention has a nasty habit of turning into trade wars. Thailand and Brazil have already moved in this direction. We shall see how a 14x P/E multiple is “cheap” as global trade and capital flows reverse course.
China seems in no hurry to engage in traditional monetary policy strategies to deal with an inflation problem that has transcended the food complex. At the same time, Chinese household inflation concerns have risen to their highest level since 1999 (in a central bank survey cited by Bloomberg News). The longer the central bank waits to raise rates and get ahead of the curve, the higher the odds will be of a hard landing. This is where the saying “a stitch in time saves nine” comes from but we don’t know how to translate that into Mandarin. But China letting the inflation genie out of the bottle wouldn’t be good news for anyone (and we see that India did, in fact, take the necessary steps and raise rates 75bps yesterday to cap its accelerating inflation trend).
The U.S. state and local governments will not be on the receiving end of as much federal aid in 2011 and yet face even larger fiscal gaps. So higher taxes and declining expenditures in this key 13% share of U.S. GDP is another clear downside risk and offset to the “goodies” that Washington just doled out (have a look at U.S. Munis Face Growing Credit Risk on page 22 of today’s FT).
Loss of confidence is a clear risk. The United States is receiving its own bail-out — bailed out by the fact that Europe is even a bigger basket case. But as government debt rapidly approaches the 90% cutoff for economic performance (and this is just the “on balance sheet stuff” per Rogoff and Reinhart) the U.S. is hardly out of the woods. Imagine embarking on more fiscal expansion at a time when structurally the budgetary gap has breached 7% of GDP and the Fed going along the road of even more radical expansion of its balance sheet at a time when:
(i) The economy is 18 months out of recession, and;
(ii) The stock market has nearly doubled from the lows. Talk about pro-cyclical government policies — fiscal policy that the country cannot afford and monetary policy being conducted in the category labeled “experimental”.
The question will be how much trust people can put into a government that is run by an executive branch that pledged to fight hard for redressing the country’s income polarization, but just did the exact opposite; and a Congress that was voted in to curb the fiscal excesses and to get the nation’s financial house in order — and yet these lame-duckers will very likely feel the pressure from the “leadership” to pretend that “pay go” never existed. Leave it to the creditors to finance these “stimulative” measures, which amazingly include tapping into the Social Security fund so as to stimulate consumer expenditures. What a way to run a country — thrift, saving and prudent are clearly dirty words in the Encyclopedia Americana. It is disconcerting that the Democrats now opt for the tax cuts they reviled in 2008 and that the GOP leadership right now doesn’t mind running up the fiscal tab even more. What exactly do these guys stand for except more “stimulus”?
While the focus will likely be on Europe’s financing challenges in the first several months of 2011, attention will at some point turn to one of the key, yet little discussed issues in the U.S.A., which will be, once again given the budgetary largesse, the legislative need to lift the debt ceiling, which now stands at $14.3 trillion. The timeline here is no later than June of next year, which means this becomes a political hot potato sometime in March or April. Shades of 1995, except back then Newt Gingrich was forced to blink because Bob Rubin found multiple ways to circumvent the problem by borrowing from a myriad of trust funds that are no longer available to such an extent. If this gets resolved, and it likely will, expect the newly elected GOP to extract major concessions — not just a freeze on discretionary program spending but even outright cuts. Then we’ll see how far the economics community goes the other way in trimming its GDP forecasts.
All that said, the equity market has clearly enjoyed a classic Santa rally this month. Underperforming hedge funds are quickly putting cash to work as they try to catch up. All of the major indices are now up double-digits for the year — the Dow up 10% on the nose (just hit its best level since September 8, 2008 even with the late-day giveback), the S&P 500 is up 11.3%, the Wilshire has gained 14% and the Nasdaq advancing 15.8%. Quite the accomplishment given where we were in July and August — thanks Ben B!
But beneath the price surface, volume is tepid, the leadership board is starting to fade and the NYSE advance-decline line is looking a tad troubling. All this nagging technical stuff does not usually begin to resonate until the inevitable correction takes hold. The stock market was languishing in late August and then it got hit with a trio of “good news” between QE2, the mid-term elections and a nice round of fiscal expansion. But the problem for 2011 is that: (i) the new FOMC voters will likely vote against more QE, (ii) there is no mid-term election, and (iii) the new folks in Congress are going to do more to limit or reduce fiscal stimulus instead of reinforcing it.
Even with the recent spate of positive economic news, the primary trend remains one of disinflation or even mild deflation. This reality will inevitably reverse the uptrend in bond yields as was the case in the past year. While the CPI is reviled by the bond bears, go have a look at real-life examples such as Retailers Offer Even More Sales on the front page of today’s USA Today. According to ShopLocal, which does localized online circulars for several U.S. chains, “retailers’ daily offers this year exceeded any of the last four years right before and after Thanksgiving.” As an aside, one has to really wonder what sort of market we have on our hands when there is so much jubilation out of the November retail sales when outside of toothpaste, pasta, sweaters and gasoline, spending actually contracted. Not to mention BestBuy’s stock sagging to its lowest level in three months as the company missed its bottom-line and cut its sales outlook. Indeed, the weekly chain store survey data for December so far do not look that great.