13th October 2014 by The Harried House Hunter
A mood has descended on the markets making them skittish and downbeat. The Fed and the IMF didn’t help last week, talking down the growth outlook. There are worries about disease and war and nothing is cheap. So core bond yields are lower again and the slide in oil prices has added to deflationary concerns. It could be like this for a while, particularly if central banks don’t come up with anything new in the face of declining inflationary expectations. Or, equally likely, the mood could change again as investors look to equities and high yield to boost returns into year end. We are almost back to the summer doldrums levels on the S&P and have been even lower in US high yield. With the US economy strong I am more inclined to look for a rally back rather than a protracted further decline.
Feeling gloomy? – Confidence remains a scarce commodity in the global economy. As I discussed the week before last, there is more uncertainty about the range of economic outcomes over the next couple of years as the process of normalisation of monetary policy eventually starts, and this is potentially having an impact on investor sentiment. The mood has not been helped during the last week by the publication of the International Monetary Fund’s (IMF) latest outlook and the minutes of the last Federal Open Market Committee (FOMC) meeting. In its World Economic Outlook, the IMF revised down its forecast for global GDP growth this year to 3.3% from the 3.7% estimate made in April, and lowered the 2015 forecast to 3.8%. It cited the weakness of growth in the first half of the year and a challenging environment for many emerging market economies. Separately, the minutes of the September 17 FOMC meeting were released and contained references to the Federal Reserve’s concerns about weakness of growth in the euro area and other major economies combined with the potential further strengthening of the dollar being a downside risk to the US economy. It also revealed a downward revision to growth and inflation forecasts by the Federal Reserve’s staff. Despite some clear disagreements between FOMC members, the minutes also revealed that the committee had decided to still characterise the US labour market as displaying significant signs of under-utilisation. If this is the message coming from major international financial institutions and policy makers, no wonder markets are skittish. Just look at the price action of the Dow last week – down 272 points on Tuesday, up 275 points on Wednesday and down 335 points on Thursday. The VIX is at its highest level since last December and treasury yields their lowest since last June, bringing with it a flatter US treasury yield curve.
Richer by far – There are other things that are worrying. Oil prices have slid in recent weeks, as have other commodity prices. Inflationary expectations have also moved lower with the ECB’s 5y-5y forward measure of inflation expectations having fallen decidedly below 2.0%. And the news flow is not exactly brilliant is it? Turmoil in Iraq and Syria, Ebola, ongoing fighting in Eastern Ukraine and calls for democracy in Hong Kong. The world is in a bit of a funk. But, get a grip people. Rates are super low and normally we celebrate lower global energy prices – particularly at this time of year – as a boost to real incomes. It’s hard to see a recession just emerging out of nowhere unless the current phase of poor sentiment leads to wholesale selling of risk assets and a destruction of paper wealth. According to the Fed’s “Financial Accounts of the United States”, household net worth rose by $1.4 trillion in Q2 alone as a result of higher stock and house prices, and net worth at mid-year was 10.4% higher than a year earlier and 40% higher than at the beginning of this recovery in 2009. So people should be feeling pretty confident about their wealth, at least in the US. Look at the employment data as well. The unemployment rate fell below 6% in September and 2.64 million new non-farm payroll jobs were created in the 12 months to September, which amounts to a growth rate of employment of just under 2.0%. The weekly jobless claims numbers are running below 300,000. Even average hourly earnings growth has been rising. It’s hard to knock the US economic picture right now.
No conviction – I’m not downplaying downside risks to growth. There is clearly scope for momentum to weaken, especially on a global scale. The Fed remains reluctant to make its forward guidance more concrete because it is clearly worried about the rest of the world in addition to what tighter monetary conditions might do to domestic spending. The bond market seems to have capitulated on monetary tightening even if the FOMC minutes indicated surprise that the forward interest rate market appeared to be pricing in less tightening than that implied by the famous dots. The September 2015 euro-dollar interest rate futures contract has rallied since the beginning of the month, illustrating this reduced conviction about higher rates next year. Bond market participants do indeed have little conviction – they have had little conviction for months. Previous attempts to bet on higher rates through short duration strategies have largely backfired while the comfort of being long high yield has been disturbed by increased volatility in that part of the market. But after a poor September for returns, October is being boosted by lower yields. It is very confusing but the secular trend is lower bond returns going forward. In the short term, with little good news on growth outside of the US, the mindset is reverting to “downside risks, therefore, lower for longer”.
If you like equities, you’ll love junk – I suspect there is going to be an opportunity to buy risky assets soon. Anyone that has access to a Bloomberg screen should plot the S&P index with the US high yield total return index. They are highly correlated and respond to the same things at the same time. The Fed is going out of its way to prevent an interest rate shock – quite clearly in the wake of the FOMC minutes – while it is not clear why there should be a growth shock. The Citibank economic surprise index for Europe is at its lowest in over a year which means sentiment is particularly weak. The actual data can still come out weaker than expectations but the extent to which there will be huge surprises to the downside is probably quite limited now. The same index for the US is bang in the middle of its range and it is the lower end of the range for China and Japan. The point is that expectations are not particularly bullish – as we know – so there is potential for a bounce in sentiment and buying of equities and high yield assets again. Risk free assets have become very expensive again relative to risky assets, more so than is probably justified in the short term by the reality of where we are in the policy cycle.
Reserve accumulation is slowing, is slower world trade a symptom of re-balancing? – Finally, a word on currencies. I don’t believe we are anywhere near the kind of activist currency policies of the past. The Fed may have made some reference to the strength of the dollar in the FOMC minutes but that is very different from doing anything about it. Similarly with the ECB, with references to a strong Euro earlier this year. In the past when policy makers wanted a weaker currency they did it by discrete intervention or, to put it another way, adopting “beggar thy neighbour” policies. The actual mechanics of that included buying foreign currency and selling domestic currency such that foreign exchange reserves tended to increase over time. Or put it another way, rapid increases in foreign exchange holdings were typically a symptom of mercantilist trade policies and undervalued currencies for the country in question. Interestingly, the pace of foreign exchange reserve accumulation has slowed in recent years pointing to both a reduction in global imbalances and less willingness and need to intervene in currency markets. The US current account deficit has certainly come down and Japan and China’s surpluses have been reduced. Furthermore, reflationary policies have focused on quantitative easing (QE) and domestic credit creation rather than trying to stimulate export growth and imported inflation. That doesn’t mean we won’t get currency market volatility nor that market manipulation won’t become a choice for some policy makers, but there is little real evidence of it just now. The dollar has strengthened against most major currencies this year but the Fed is unlikely to be overly concerned about this. What might be more worrying is that ongoing global de-leveraging and rebalancing might mean less reason for foreign exchange reserves to grow and less world trade volume growth. I can’t see re-balancing delivering a world of limited trade deficits and surpluses and reduced need for reserve accumulation. We need some countries to grow quicker than others to provide opportunities for other producers and investors. Rampant imbalances are not desirable but anemic world trade growth rates are even less desirable. With a current account deficit of 4.0% of GDP, the UK is trying to do its best. Now if only Germany would reduce its surplus.
The kids are alright – I can’t finish without mentioning that Manchester United are back in the top four of the Premier League and sit above Arsenal and (last year’s flash in the pan), Liverpool. The Gaalacticos are settling in and Di Maria got another goal last Sunday. It’s going to be hard to catch Chelsea or City but games against those two are coming soon. I just hope somewhere Alan Hansen is going to say “you can’t defend against the likes of Aguero or Da Costa with kids”.