In almost every asset class, volatility has made a phoenix-like return in the last few days/weeks and while equity markets tumbled Friday into month-end, the bigger context is still up, up, and away (and down and down for bonds). From disinflationary signals to emerging market outflows and from fixed income market developments to margin, leverage, and valuations, here is the 'you are here' map for the month ahead.
Via Russ Certo of Brean Capital,
Treasury yields surged to their highest level in more than a year last week with the 10yr note yield touching 2.22 bps mid-week vs. 1.60 yield as recent as May Day. The 30 year mortgage rate rose above 4%. Paul Volcker said benefits of buying bonds are "limited and diminishing" and that central banks are often late in removing stimulus.
The S&P 500 ended the week off 1.14% as volatility returned across financial landscape, led by Nikkei which fell 5.73% on the week and over 12% in two week period. It was also revealed that Euro-zone unemployment rose in April, to a new high of 12.2%, or 19.3 million people. In this demographic the young are nearly three times as likely as older people to be out of work.
The S&P 500 snagged its best month since January and stretched its string of consecutive monthly gains to seven, the longest since 2009. The Dow has risen in 17 of the last 20 months and is up 14.3% in 2013, scoring its best five month start to a year since 1997.
As the week started, price action reflected investor enthusiasm regarding housing recovery as Case/Shiller housing price index showed prices spiked 10.9% in March from year ago period and ALL 20 metro areas measured posted gains for the third month in a row. Although as we know, the week didn't end with such enthusiasm as the Dow slid 208 points on Friday.
As Barron's notes this weekend, the climb in housing prices over the past year has added more than $1 trillion to the market value of single family homes, causing a "wealth affect." Consequently, consumer spending rose at the second fastest rate since Great Recession. Moreover, residential investment has grown over each of the past eight quarters.
But the devil is in the details, government guarantees of home mortgages are at 91.6%. VA and FHA have insured 46.4% of all mortgages, a huge increase from around 10% in 2007. Most of the loans in this program have zero to 5% money down. If mortgage rates were to rise to 6%, like 2006, from recent lows of 3.5%, monthly payments on a 30 year fixed mortgage would rise by a third, meaning the same -priced home would cost about one third more. http://www.nytimes.com/2013/06/01/business/global/in-japan-a-hard-to-budge-obstacle-looms-over-the-fight-with-deflation.html.
Regarding rates and in a relative sense, the bond selloff this month represented a 2% price drop in iShares Core Total U.S. Bond Market ETF (AGG). In other words, a year's worth of income was lost in a month. We have made the distinction recently that this bears watching for technical reasons.
The evolution of financial market structure and product engineering lends itself to the notion that fixed income products designed in the fund and ETF arena possess equity like NAV characteristics and as retail investors measure performance, negative as noted above, actual loss of principal on mark to market basis may be less than understood and digestible in the retail investment arena.
With month, quarter, and year to date negative total rate of return performance for broad swath of fixed ETF and fund asset class, performance, liquidations, and redemptions may drive sales of physical securities and BWIC in the actual capital marketplace. I noted anecdotally last week, bonds ultimately mature, hopeful at par but funds don't with an odd perpetual risk profile for investors.
For example, the iShares Barclays 20+ year Treasury ETF (TLT) lost 7.7% in May and iShares FTSE NAREIT Mortgage Plus Index ETF, (REM) which tracks REITS cratered 11.8% in May. Trading in the mortgage market was unruly last week marked with gaps in price action and vacuum of liquidity, resulting in the cheapest valuations on mortgage/Treasury basis in years.
Sell in May and go away should have referred to bonds not stocks and this particular strategy was off to a rough monthly start prior to Friday. S&P up 2.1% in May versus 6.3% decline in the month last year as most recently issued and auctioned in May refunding 30 year bond is down 9% in price similar to other fixed market declines above.
Even worse or riskier from market profile is that leveraged bond funds that allow investors to amplify low yields and augment income now make up about 20% of all assets in intermediate and long term bond ETFs launched post crises. Nearly 50 of these financially engineered funds have taken in $10 billion recently and now represent a formidable market of about $52 billion in the entire category.
Quick responsible note: guessing large percentage of this genre is retail based and decidedly less of institutional representation which could also adversely impact understanding and stickiness of assets or commitment to the sector, flighty. Even worse than that and magnifying the prospective imbalances in markets is the advent of a newer brand, low volatility ETFs, which have proliferated and grown even faster, by 1,000% this year. http://online.barrons.com/article/SB50001424052748704895304578503362134685542.html?mod=BOL_twm_col#articleTabs_article%3D1.
In fact, in a surprisingly short period as many players lulled by months/years of low volatility were looking to Memorial Day summer kick off have been met with some of the most interesting price action in years, just as the "lack of volatility" fund products and expressions have become one of the fastest growing asset classes. The above shellacking wasn't just limited to risk free rate core sovereign markets, it was also manifested in other high yielding interest rate sensitive proxies like utilities, energy master limited partnerships, dividend payers in equity space, and even commodities, bit coins, and emerging market space. Maybe, that's what Barron's was asking this weekend, "Is the Low-Beta Bubble Deflating"? http://online.barrons.com/article/SB50001424052748704895304578503473189159616.html?mod=BOL_twm_col#articleTabs_article%3D1.
It's not clear whether investors should appreciate value of declining prices in fixed income, consider further declines or contemplate exposures or imbalances more in the equity space as margin debt in the U.S., money borrowed against securities in brokerage accounts, as measured this week, has risen to its HIGHEST level ever. The $384 billion surpassed the previous peak set in July 2007.
Side-note: relative to the size of the economy, 2.25% of GDP, margin debt is far from record but has climbed to these levels relative to economy only twice in half century. In each previous case the increase came during bull markets (technology bubble and housing boom) that ended with rapid falls in share prices.
In each case there were double digit increases in share prices during the year before margin debt got to that level. In both instances, the stock market decline began WHILE margin debt was at a high level, and accelerated as debt levels fell, presumably because investors were liquidating securities that were losing money. Kind of an anecdote and aside, the FAMED Hindenburg indicator gave off a positive signal last week, suggesting imminent decline in equity prices.
Rising margin debt generally viewed as an increase in speculative fervor used to be controlled by the Federal Reserve. But the last time the Fed adjusted margin rules was in 1974, when it reduced the down payment required for stocks to 50% from 65%. That came during a severe bear market. It is reasonable to consider that the Fed utilizes a suite of other tools to manage perception of speculative excesses. This is a debate that continues to be active in the critical community. http://www.nytimes.com/2013/06/01/business/economy/shades-of-prerecession-borrowing.html?_r=0.
Record margin and what it represents for markets should also be considered in the context of record cash and futures volumes in the U.S. Treasury market in the latest week. Record futures volumes have been noted to be reflected or partially distorted in large calendar rolls but by a variety of measures the animal spirits in these markets seem to have awoken from a long hibernation.
These risk expressions are also coincident with the volatile performance of high beta asset classes around the world. Generally the recipient of capital formation seeking growth opportunity, emerging markets were reflective of this global retreat of risk as investors pulled back meaningfully from the developing world. In fact, generally benign optics of U.S. equity bourses has NOT reflected far more risk reduction around the rest of the emerging world.
The Brazilian real hit four year lows against the USD this week. This is despite the fact that the Brazilian Central Bank on Friday FAILED to stop the weakening with a foreign exchange swap whereby the bank swapped $877 million reals. In addition, the Turkish lira traded to a 17 month low to the USD on Friday even after the Central Bank governor, Basci, jawboned the bank may take additional steps to defend the lira. Investors pulled 2.89 billion out of emerging-market equity funds on the week.
Flows appear to be reversing in far stretching markets South Africa, Thailand, Indonesia and even Mexico. Mexico, one of the U.S. largest trading partners and mutually beneficial symbiotic geographical relationship, cut its 2013 growth forecast earlier this month to 3.1% from 3.5%, contributing to a more than 6% fall in the peso in May.
Bonds denominated in these rapidly depreciating currencies are vulnerable or reflect newfound value pending on your disposition. For instance, yields on peso denominated 10 year government bonds rose to 5.36% on Friday, versus an all-time low of AT THE START OF THE MONTH of 4.5%. http://online.wsj.com/article/SB10001424127887324412604578516653794315578.html.
Are markets sensing a removal of accommodation by the Fed and other central banks, not so, in above markets? Or global final demand decline? As a prospective harbinger of demand for global products and services, LOW Chinese demand contributed to a decline of 7.2% in Cotton prices in May. With its warehouses brimming with Cotton, due to excess capacity and slack demand, estimates are for imports to be 35% LOWER next season. China possesses 63% of the world's cotton stocks and one should take note when there is slack. The U.S. incidentally exports 75% of its cotton overseas. This is a residual China slowdown story even though the Barron's piece this weekend speaks of micro-specifics. http://online.barrons.com/article/SB50001424052748704895304578503492256932544.html?mod=BOL_twm_mw.
In fact, commodity softs loosely represent "stuff in the ground" and to some extent like all commodities reflect the nuances of final industrial and/or consumer demand. Cotton is a soft and the softs at large have been getting OBLITERATED. Look at coffee in the world of $4 lattes. Sugar... This particular group was and has been sending off warning signals BEFORE the varied and myriad widespread distinguished selloff expressions reared their ugly risk expression heads in global retreat. Please ask for the chart that was compiled for me by our friends at Business Insider which called attention to this anomaly WHILE most global risk expressions like credit spreads and equity bourses were charging to new all-time high valuations. This "soft" asset class is really making a statement, even last week with broad impressive further declines.
Of course, China is the manufacturer of last resort of all sorts of demand side products and commodity usage to the rest of the world and Euro-Zone jobless rate, as aforementioned, hit a record of 12.2% last week. This is the highest rate for the Euro-zone since records began in 1995 and may reflect why Chines manufacturing warehouses are loaded with excess capacity, like cotton. http://online.wsj.com/article/SB10001424127887324412604578516770987948166.html.
Asian buyers shun U.S. Wheat: Demand, liquidity, monetary tidings, and trade. http://online.wsj.com/article/SB10001424127887324682204578516980611548920.html.
Thomas Donlan in Barron's editorial frames that "a brief victory in a currency war is likely to produce a long defeat" as applied to Japan. 20 years of zero rates and rising national debt of 225% of GDP, 10 year $2.4 trillion infrastructure projects and with borrowing costs of less than 1% IS consuming a QUARTER of all NATIONAL tax revenues. He crystallizes the obvious, a currency war for trade. http://online.barrons.com/article/SB50001424052748704509304578515382444398340.html?mod=BOL_twm_fs.
Japan: Vending machines in Japan have become a stubborn barometer of the country's struggle against deflation. Many vending machines in Japan sell soft drinks for prices lower than they were in the 1980s. http://www.nytimes.com/2013/06/01/business/global/in-japan-a-hard-to-budge-obstacle-looms-over-the-fight-with-deflation.html.
Ironically, Chinese yuan achieved a record level against the USD last week and was signified by $7.1 billion acquisition interest in Smithfield Foods, hogs to feed the people. Bringing home the bacon: http://online.barrons.com/article/SB50001424052748704895304578503472241992676.html?mod=BOL_twm_col.
Marc Faber is not left out of the discussion as Barron's featured a weekend interview. His perspective of the broad consequence of world finance characterized by years of money printing are well known. He details that stocks, bonds, art, wine, jewelry, and luxury real estate are all the beneficiaries of monetary tidings. Hampton's property prices rose 35%, condos in Manhattan selling for over $100 million, record art sales, and 60 gains in the Nikkei. But central bank policy not reaching the worker in Detroit. He claims China's "huge credit bubble" as not going to end well. Provocative article titled, "Bubble, Bubble, Money and Trouble." http://online.barrons.com/article/SB50001424052748704509304578511561194530732.html?mod=BOL_twm_fs#articleTabs_article%3D1.
Which brings us back full circle to the Fed and global central bank policy. On Friday, a key gauge of inflation fell in April to the LOWEST LEVEL ON RECORD, a drop that could take pressure OFF the Fed to wind down its asset purchases. Core prices in the deflator rose 1.1% from a year earlier. For the 17 countries that share the Euro, consumer price inflation in May was 1.4%. In Japan, core consumer prices fell .4% in April. http://online.wsj.com/article/SB10001424127887324682204578517443946630024.html.
This Friday consensus estimates for May nonfarm payrolls is a gain of 175,000 with jobless rate constant at 7.5%. Some suggest less is more and more is less from a central bank policy prerogative point of view. Weaker number, more stimuli in form of reduced tapering of Fed purchases, steroid juice to ailing markets. Strong number, reduced asset purchases, removal of liquidity and animal spirits.