Sentiment in risk asset markets has taken a sharp turn for the better in 2013 year to date, and the bulls are making a rather compelling case that the good times may roll on for awhile yet. The S&P 500 surged to yet another record level on a jetstream-strength tailwind of $19.7 billion of net new assets poured into global equity funds. That’s the most since June 2008, as good a sign as any that the fear-greed pendulum has well and truly crossed the full horizon. That being said, the funds flow has been unusually concentrated. Of that $19.7 billion a full $17.5 billion went into US funds, and $6.5 billion into one single asset – the SPDR S&P 500 exchange traded fund (SPY). No wonder the S&P 500 is proving to be such a formidable benchmark for active money managers to beat this year.
Bye Bye Bonds
The gains in equities have come at the expense of bond funds, which saw $700 million of net outflows. Most of the outflows relate to rate-sensitive areas like US governments and investment grade corporates, along with emerging markets funds, while high yield funds saw sizable net inflows. That is not altogether surprising, as high yield bonds often exhibit trading patterns closer to equities than to other bond asset classes. This week’s bond exodus didn’t do much to move the needle on broad market yields, though. In fact the 10 year yield has generally trended downwards over the week, staying just below 2.5% as Friday trading approached the close.
Banks Rock, Techs Lag
With around 25% of the S&P 500 companies reporting on 2Q performance thus far the picture is a bit more mixed than the general euphoria of weekly funds flows. Financials are leading the way and tech, laden down by Apple, is bringing up the rear. The financial sector overall is showing earnings growth of 24.3%, highest overall for the second quarter in a row. In fact when you take financials out of the equation the blended earnings growth rate for the S&P 500 overall falls from 1.1% to -3.5%. Big names like Citigroup, JP Morgan and Bank of America have provided much of the strength, and interestingly the consumer finance subsector is the strongest overall. Rock on, US credit card users.
Apple as Albatross
If giant banks are a blessing to the financial sector, one behemoth is proving to be a curse on the tech sector. That would be Apple, the largest company by market cap on the S&P 500. Earnings growth for S&P technology companies is -9.4% based on current consensus expectations, but if you take Apple out of the equation that jumps to only -6.9%. Perhaps most ominously, sales of iPads are projected to fall 14% over the next year. The iPad Mini is experiencing some stiff competition in that space from Amazon’s Kindle, among other factors. Proving yet again that when it comes to tech, yesterday’s darlings can find it challenging to sustain the high expectations that come with being #1.
The phrase “BlackBerry Panic” gained currency back in the dark days of 2008. It was a wry, very apt touchstone for how policymakers kept one nervous eye on the flashing screens of their smartphones while trying to figure out how to save the financial world from ruin. Well, it’s 2013 now. BlackBerries are well on their way to becoming quaint relics of a time gone by, and financial Armageddon is not looming directly overhead. But whether from a high resolution iPad 4 or a sleek Samsung Galaxy, the daily upticks and downticks of asset prices continue to jump out of cyberspace and into the attention spans of Ben Bernanke and his Board of Governors colleagues.
After the sharp run-up in bond yields and a (relatively minor) correction in US equities, Bernanke used his microphone time this week to belabor the point that there is no definition of “tapering” in the dictionary that equates to “imminent rate hike”. Markets got the point. The S&P 500 clawed back all of its June losses and then some, closing out July 11 at 1672. The 10-year Treasury yield fell back below 2.6%, and the VIX Volatility index – Wall Street’s “fear gauge” – crawled meekly back below 13 after surpassing 22 in late June. So the gods are in Valhalla and all’s right with the world?
Beware the Net Outflows
Not necessarily. It’s perfectly understandable why Bernanke wants to jawbone markets, particularly bond yields. The surge from 1.6% to 2.7% on the 10 year note was overblown and not justified by credit market fundamentals. But investor behavior is not rational, and an outcome of selling begetting more selling could inflict real damage on business decisions around hiring, capital investment and the like. Hence Bernanke’s deliberate spelling out the difference between tapering and an actual change in interest rate policy.
Kick the Habit…But Not Yet
But the subtext to this is that once again the policy goalposts are susceptible to being moved. Since the announcement of QE3 last year the oft-quoted benchmark for economic improvement was an unemployment rate of 6.5%. Now some of the more dovish Fed governors are floating 6.0%, or maybe something else instead. “We’ll know it when we see it”, one supposes the governors to be saying to each other in their private conversations. Meanwhile, keep the punchbowl spiked so that assets don’t do something crazy like go off and respond to actual, real supply and demand dynamics.
Waiting for Capitalism
Amid the nervous chatter in the past several weeks there have been not a small number of voices expressing pleasure in the expectation that these real-world fundamentals might be on the horizon again. Sure, there might be a few months or more of unpleasant adjustment, but then the patient will be able to stand on its own two feet again. Credit markets can reflect the equilibrium between borrowers and savers without the Great Nanny hovering overhead with $85 billion worth of monthly injections. We’re not there yet. When Ben Bernanke switches off his smartphone and sits down to make policy without wondering where the Dow’s at, or how much net outflow took place in bond mutual funds this week, then we’ll be a bit closer to letting capital markets do what they do best – to discover their own prices and values.
They conferred in elegant conference rooms in the classical-style École des Beaux Arts building that houses the Federal Reserve Board, to discuss the problems created by years of pumping cheap money into the economy. The need for that cheap money is no longer a present day reality, they said. In anticipation of a resumption of economic growth we must raise interest rates from the recent low levels that have never been seen in the history of our Republic – a 1.6% yield on the 10 year Treasury! The policymakers acted accordingly, and a 30 year macro bear market for interest rates ensued.
Coming Full Circle
No, that is not a speculative musing about the future, but a recitation of actual US economic history. The year was 1951. The cheap money was the legacy of an economic depression and, more recently, the cost of financing the country’s involvement in the Second World War. The US was the world’s sole economic superpower and its only viable source of growth, but the monetary policymakers of the day knew that real growth could not come on the back of cheap money. No free lunch they said, rates have to rise. And rise they did, with the 10-year yield going from 1.6% after the war to 15.4% by 1981.
Now we have come full circle. After five years of historically cheap money investors are looking at the bond market, and nightmarish visions of that 1951 Treasury Accord are dancing in their heads. With one day left in the second quarter the Barclays US Aggregate Bond index has returned -2.43% since April 1. The exit doors are jammed with fleeing moneyfolk – in the last four weeks $23.7 billion has left the bond market via net mutual fund outfllows, the most since the days of indiscriminate panic selling in October 2008. By comparison the S&P 500 is up by 3.4% for the quarter even after the recent 5.8% correction.
The Gathering Storm?
That frenetic selling is not helping bonds regain ground. When investors pile out of an asset the managers who run funds holding those assets have to sell to redeem the exiting investors. That selling drives prices down further, leading to more investors getting out, and a vicious circle ensues. There’s a bit of that going on now – quite honestly there is not a compelling case to make on the basis of economic fundamentals for the 10 year yield to jump from 1.6% to 2.6% in just five weeks. We imagine it likelier than not that cooler heads will prevail in the near term. But we have glimpsed the shadow of the bear, if not yet the bear itself.
Unfortunately there’s not much in the way of safe houses in today’s environment. Bonds are down, stocks are off their highs, commodities are faring poorly and there is great carnage in emerging markets. If we are headed towards renewed growth, as we continue to believe is the likeliest scenario, then presumably this too will pass. But it’s not a good time for the queasy or the faint of heart.
Bond rates are rising. This week the Fed met and the world learned the true meaning of “tapering”: not a slip of the tongue, but a stated willingness on the Fed’s part to contemplate a phasing out, over time, of the QE programs that have kept assets afloat through the near-crises of the past several years, from the Eurozone turmoil to Washington’s repeated fumbling of its role on the world economic stage. The 10 year yield as of this writing is just under 2.5%, about 50% higher than where it was at the beginning of May. Bond traders are smelling the end of an era, battening down their durations and searching for ways to be low-correlated to the Barclays US Aggregate.
Here’s what else is not finding favor in the current environment: commodities of all stripes from gold to industrial metals to energy. It’s a far cry from the distant days of the last period of sustained rising interest rates in the mid-late 1970s, when gold rushed to an all time (inflation-adjusted) high and real-return or “hard” assets generally were the only bright spot in investment markets. Gold is down by more than 10% since the beginning of May and more than 30% off the nominal highs reached in late 2011. Households notice that gas prices haven’t been jumping in typical fashion as the summer driving season gets underway. Prices of copper, aluminum, natural gas and other commodities are similarly depressed.
…With Subdued Inflation
There are some good reasons why commodities are in a slump, first and foremost of which is that inflation is not a high-level threat in the near term. Real assets tend to do well when inflation is high and the US dollar is weak, neither of which is a present reality. Rising rates aren’t driving investors to real assets because the rising rates – for now anyway – have little to do with inflation and lots to do with a long journey back from the artificial low-rate policy regime of QE. Simply put, even after the recent run-up rates are historically low and thus even in the absence of inflation more prone to rise than fall.
The Slow Return to Market Economics
Low inflation and the Fed’s desire for an orderly transition from QE mean that the road to higher rates will more likely play out over time than overnight (the one big caveat being an excessively negative momentum cycle in bonds exacerbated by high frequency trading programs). Eventually rates should fall in line with real economics: how much money is coming into the economy and how much output (goods and services) is being created to meet that demand. When too much money chases too few goods inflation will result, rates will rise and real return assets will offer value. Then activity will slow, rates will fall, borrowers will take advantage of lower rates and the cycle will begin again. That’s how the system is supposed to work. It will be a refreshing change to get back to it after the looking-glass world of QE.
The doctors may be at odds about how and when to start reducing the morphine treatment, but the patient is having none of it. When Dr. Bernanke chose to use the word “tapering” during the Fed’s May 22 meeting, carry trade investors of all stripes heard the flow of their daily stimulus fix (the low rates that finance their profitable adventures into risk assets) threatening to slow down to a measured drip-drip. We won’t go, go, go they chorused as prices on US stocks and emerging markets bonds and global REITs and much else besides jagged to and fro in increasingly volatile trading sessions.
It’s still all about the Fed. When the S&P 500 jumped up by 1.5% on Thursday of this week it was an unconfirmed report in the Wall Street Journal implying that the Fed wouldn’t be backing off its QE3 operations any time soon that set the bulls on the charge. Whether yesterday’s sudden burst of optimism sets the pace for a sustained push back towards the index’s May 21 high water mark of 1,669 probably depends more than anything else on how Bernanke chooses to articulate the central bank’s current thinking at the forthcoming Board of Governors meeting this next week. Here’s a thought: It is rather unlikely that the word “tapering” will venture forth again from his calm and measured lips.
An Interim QE Report Card
With the myopic focus on day to day movements in asset prices it is sometimes easy to lose sight of the fact that the Fed’s policy tool of choice, quantitative easing, is primarily aimed at the more pressing objective of bringing the economy back to health – as defined by growth in economic output, income and especially employment. The theory underpinning QE is that by driving asset prices up, monetary policy engineers can encourage the wealth generated from the higher values to spill over into the economy at large. That theory may prove valid in the end, but the jury is still out.
So far the post-2009 recovery has failed to produce a single full calendar year of 2.5% growth, which is a benchmark level for sustainable (albeit moderate) job-creating growth. The unemployment rate has fallen from a high of 10% year-on-year reached in October 2010 to 7.5% in April 2013 (ticking up again slightly in May as more out of work adults came back into the market looking for jobs). That is an improvement though the pace is slow. After the recession of the early 1980s unemployment fell from 10% to 5.5% by the second half of the decade. At current GDP growth rates that will be tough to match.
Look Ma, No Hands
Recent news has given reason for optimism, though. Payroll numbers have been trending up as of late, consumer confidence is resurgent and housing price gains are shoring up household balance sheets. Perversely, it’s the optimism of recent data points that have added to investors’ funk. It’s when signs of better health appear that the doctor starts to wean the patient from the treatment. At least for now the patient is not ready, and it’s unlikely that the doctor is going to push him out the door too quickly. That’s probably the right thing to do. But the concern is that when the body gets too used to the treatment, the treatment becomes less and less effective. And that in turn could call into question the course of the recovery. Dr. Bernanke has a fine line to walk this coming Tuesday, and both his policy choices and his verbal acuity need to be sharp as a tack.