Posts published in May 2015
Well, that was interesting.
On April 20, all the chatter among bond traders was about the imminent plunge of 10-year German Bund yields into negative territory. Instead they were caught off guard by a sudden, steep and seemingly inexplicable reversal. The 10-year yield doubled within two days, on its way to a stunning eightfold gain by mid-May. Meanwhile the 5-year yield, which had languished in negative territory since the beginning of the year, broke through the zero bound on its way to a peak of 0.11%. Other assets reacted accordingly. US Treasury yields jumped, the euro broke out against the dollar, and commodity prices gained.
No Friend, This Trend
Then, just as quickly as it began, it was all over. As the chart below shows, the sharp reversals that began in late April reached a peak in mid-May. With barely a pause to enjoy the view from on high, the reversals reversed. Eurozone yields, the euro and commodities fell in tandem. The 10-year Treasury also pulled back from its mid-May high though, interestingly, the 2-year yield remains elevated.
All this has resulted in a collective head-scratching among market observers, particularly with regard to what drove that initial sudden spike in Bund yields. Some pointed to liquidity concerns as a result of increased ECB purchases, while others posited the incongruence of negative yields with somewhat improving Eurozone growth and inflation prospects. A handful of weaker than expected data points in the US may have helped the dollar’s decline. None of these explanations, though, make a convincing case for the timing and magnitude of the reversal. A more plausible explanation may simply be technical: a bevy of algorithms were programmed to kick in when the 10-year Bund approached zero, and traders duly piled on.
Back to the Periphery
Another curious feature of the April-May reversal was its concentration in the core, rather than the periphery, of Eurozone yields. Peripheral spreads actually tightened against the Bund during this period. The chart below shows the year-to-date trend of the Spanish 5-year benchmark issue relative to the 5-year Bund. Spanish yields rose by less than Bunds through mid-May, but the spread has widened notably since then.
This chart may indicate that things are returning to “normal” in Europe. As investors return their focus to the deteriorating situation in Greece, the risk premium on peripheral debt like Spain increases while the Bund resumes its traditional safe-haven role. The slow pace and contentious nature of the negotiations between Greece, its EU partners and the IMF have increased the potential for a so-called “Grexit”. That day of reckoning is not yet at hand – the IMF has given permission for Athens to delay its June debt payments until the end of the month. But after more than three months of negotiations there is little evidence of convergence towards mutual agreement.
Meanwhile, Back in the US…
If the chart above illustrates a reversion to more typical core-periphery spreads in Europe, we believe it also indicates that US rates will likely decouple from trends in the Eurozone. There was no particular reason for Treasuries to join the European April-May trend; if anything, consensus opinion here has pushed the likely timing of a Fed move further back into the second half of this year, if not later. We will have a better sense shortly as to whether the US weakness is a first quarter phenomenon or a more chronic ailment. That, in turn, will give us a better sense as to where rates here are headed.
History doesn’t repeat itself, but sometimes the rhyming is uncanny. As the first half of 2015 heads into its final month, perhaps its most distinguishing feature is the resemblance to 2014 through the same third week of May. An early stock market pullback with volatility spikes, a sharp recovery in February, some lousy macroeconomic data points, and then a meandering S&P 500 within a fairly tight band of support and resistance levels are characteristic of both this year and last. And in both instances we see a nascent pattern of upside breakout and falling volatility in that third week of May, illustrated in the chart below.
In 2014 that late-May uptick morphed into a summer of tranquility. The VIX plummeted to near-record lows while stocks glided gently upwards through June and July. Can we expect a similarly idyllic drift down the river as this summer gets underway, or do more Andean volatility peaks lurk around the next bend?
Waiting for GDP…
A robust 2Q GDP report would really ice the cake for the 2014/15 comparison. Last year’s 2Q showing of 4.6% real GDP growth put to rest the fear that the 1Q contraction had to do with anything more than the unusually cold winter across most of the country. We won’t know this year’s 2Q figures until late June, but anything over 4% would be well ahead of the current consensus. For example the Atlanta Fed, which correctly predicted the below-consensus 1Q outcome, expects 2Q GDP to come in at a paltry 0.9%. Following a string of unimpressive retail sales numbers and recent reversals in the consumer confidence index, the 2Q GDP number takes on particular significance this year. The prevailing meta narrative for the past couple years has had the US leading a global recovery which, if modest by past norms, is at least positive enough for reasonable job creation and wage growth. Yet Europe and Japan – perennial laggards both – grew more in the first quarter than did the US. Continuing sub-2% growth could prompt investors to revisit the assumptions underlying their asset pricing models.
…and the Fed
The FOMC’s next conclave is June 16-17, a week before the 2Q GDP numbers come out. The timing makes it very unlikely that we will have any definitive guidance on rates when Chairwoman Yellen faces the cameras on the afternoon of the 17th. Today’s April Consumer Price Index release was mildly bullish, with core CPI (ex food and energy) trending up to 1.8% year-on-year, but still below the 2% target. The final headline number the FOMC members will have to take into their June meeting will be May jobs, due out a couple weeks from today. Unless payroll gains come in over 300,000 or below 100,000 (either of which, of course, is possible) it is hard to see what could move the needle enough to induce the Fed to either give a date or take a 2015 hike off the table.
No News is Good News?
The lack of conclusive evidence either for the economic growth narrative or the Fed’s timing may, in the absence of any other X-factor surprises, work to the market’s advantage in a version of “ignorance is bliss”. Indeed the current sentiment appears blissfully placid. The surprising recent spike in European bond yields has done little to shake this complacency, with shares trading up and the VIX staying mostly below its 1.5 year average. The recently concluded earnings season had little impact on share prices one way or the other, despite dire predictions going into the season. And geopolitical news continues to be the yawn-inducing nonevent that appears to have become the norm. While a seismic pullback is never out of the question, we see little to indicate that one is right around the corner. “Sell in May” would have been poor advice in 2014, and we are not inclined to do so in 2015.
“Stocks always go up in the long run, except when they don’t” may be how Yogi Berra would have described the performance of Japan’s asset markets for the past quarter century. In the depths of the global financial crisis in early 2009, the Nikkei 225 stock index was worth less than 20 percent of the value it held (in nominal terms) at the giddy heights of the late-1980s shares and real estate bubble. The chart below tracks the pain long term Japanese investors have endured in their 25 year journey through the capital marketplace’s deep north.
Those long-suffering investors have been having a better time of it as of late, though. Since the election of Prime Minister Shinzo Abe in late 2012, the Nikkei has jumped a cumulative 119 percent and has recovered fully half of the ground lost from its peak at the end of 1989. Shares are up more than 12 percent in local currency terms so far this year. Will the road to recovery continue? Or is halfway to breakeven as good as it’s going to get before winter comes again?
Prime Minister Abe’s program for reinvigorating Japan’s moribund economy has three components, or “arrows”: monetary stimulus, fiscal expansion and structural reform. The Bank of Japan has certainly delivered on the first component. Japan’s quantitative easing program is larger in magnitude, relative to the country’s GDP, than either the Fed’s trio of QE sprees or the ECB’s more recent bond-buying bonanza. But the stimulus has thus far failed to deliver on the promise of igniting prices. Year-on-year core inflation as of March remained stuck at zero percent. And that is due at least in significant part to the chilling impact on domestic demand released by the second arrow. Consumer spending plunged in the wake of last year’s hike in the consumption tax, resulting in a negative GDP for the year. Consequently, Abe had to put the second arrow back in its sheaf, postponing the next hike in the consumption tax rate until 2017.
Arrows for Dinosaurs
That leaves the third arrow, by far the trickiest of all. Structural reform is never easy, least of all in the plodding, hidebound bureaucratic and corporate culture of Japan. The most notable single feat Japan’s collective business powers have accomplished in the last twenty years is conspicuously failing to take advantage of the growth opportunity presented by China Rising. In sharp contrast to the way they successfully penetrated the US market a half century ago, almost none of the leading Japanese companies managed to get in early and capture meaningful market share in China’s blossoming industry sectors. In contrast to the luster of, say, China’s Alibaba or South Korea’s Samsung, Japan Inc.’s once awe-inspiring brands are largely tired and shopworn.
With that said, though, Prime Minister Abe has taken aim at the famously thick red tape that has long made doing business in Japan a uniquely difficult challenge. He has pledged to submit at least twenty bills to the Diet (Japan’s parliament) this session to tackle key areas such as high corporate taxes, uncompetitive utilities, healthcare costs and pointless regulations. He needs to. Having failed to achieve the 2 percent inflation target by its original deadline, Abenomics needs a strong tailwind of economic growth to have any hope at all of having something to show for itself by 2018. A weak yen, low energy prices and low interest rates could still help here, but none of those variables can be relied on to continue for the foreseeable future and may conceivably reverse course.
Buybacks and Wages and Capex, Oh My!
What Abe would really like to see that third arrow do would be to tap into the deep well of cash businesses have been piling up for most of these lost decades. There are some signs that businesses are getting the message, announcing sizeable shareholder buyback programs and repatriating earnings from abroad to invest in domestic expansion programs. And with unemployment at a tight 3.6 percent, Japanese workers can expect to see a bump in their paychecks, which in turn could help boost consumer spending. The outcome of this year’s shunto – the annual negotiations between businesses and labor unions – was a 2.43 percent increase in wages. That’s real purchasing power at current inflation rates, and perhaps a sign of brisker times ahead.
Japan’s recent economic history makes it challenging to put too much faith in its ability to deliver the goods. If Prime Minster Abe is not able to produce at least one or two meaningful measures of success in structural reform by this summer, there may not be much additional upside in Japanese shares from their present levels. And the fiscal problems will have to be dealt with sooner or later – Japan’s budget deficit currently stands at 6.2% of GDP. But it would be advisable not to write final epitaphs for Abenomics just yet. The country has snapped back from daunting odds before. It may yet do so again.
This week we found out that US labor productivity – the output of goods and services per hour worked – of nonfarm workers fell by 1.9% for the second consecutive quarter, bringing the 5 year average to a measly growth rate of only 0.65%. This information comes on the tail of last week’s disappointing news that the economy grew at a mere 0.2% during the first quarter (just an initial estimate – but still). “Fret not!” says Positive Polly – we had another rough winter this year which is probably why the GDP numbers are less than stellar. Labor productivity will increase in time. And unemployment is the lowest it’s been since May 2008!
Indeed, the fundamentals don’t look terrible – the recent jobs numbers have been mostly promising, and (with the exception of Q1) GDP was positive in 2014. But what will it take to return to growth comparable to – or even half as robust as – we saw during the 1990s?
Working 9 to 5
The workforce would seem to be steadily increasing. New jobs have been added every month since September 2010 and, while not at levels pre-financial crisis, the unemployment rate is at a respectable 5.4%. However, there is a dark underlying truth: we have an aging workforce, slowing population growth and (as per the trend described above) slowing productivity. By 2020 approximately 25% of the workforce will be at least 55, and most baby boomers cite their optimum retirement age at 66. This means that by 2030 the majority of baby boomers will no longer be working, and the population hasn’t been increasing enough to support a one for one replacement for this large portion of the workforce. Many women are waiting longer to have children – in 1970 the average age of first time moms was 21 and by 2008 it had increased to 25.1. The birth rate has declined every year since 2007.
Gen Z Bails on After-School Jobs
Another trend working against labor participation growth is at the young end of the labor pool. After-school jobs have become less en vogue with high schoolers, who in other times took on a variety of jobs by way of introducing themselves to the work force. Employment among 16-17 year olds is lower today by 7.8% from its level in 2005. More teenagers are pursuing higher education (census data estimates that only 28.8% of baby boomers earned a bachelor’s degree or higher) and after school work is taking a backburner to SAT prep courses and other pursuits deemed more likely to impress college admissions offices. So not only is the younger generation dropping its after-school jobs, it is also delaying its entrance into the workforce. That also skews the average workforce age higher.
A declining rate of workforce and population growth leave productivity as the only viable path to a faster-growing economy. So we need to pay close attention to what has caused our labor productivity to slow down for the past 5 years. The easy answer would be that the financial crisis is the root of all our productivity problems. But let’s not forget that the recession ended in July of 2009, and even with the combination of a growing workforce and below-trend wages, productivity is still suffering. One reason for this could be due to the fact that companies have prioritized giving money back to shareholders (mostly in the form of dividends and share buybacks) over investing into their businesses. This trend has intensified since 2009. As the old saying goes, you have to spend money to make money. Unless businesses find new ways to invest in and improve the efficiency and effectiveness of their process flows, it may be tough to move that productivity dial much.
Other economists argue that productivity slowed when the technology boom of the 1990s ended, which would signify a much more concerning growth problem in the US. Innovation in the 1980s and 90s saw workplace productivity improve immensely, fueled by adaption of successive Information Age technologies like the PC, client-server networks and Internet 1.0. Now, innovation is not dead – cloud computing, social media and 3D printing are just a few of the technologies which have disrupted traditional industry structures since the dawn of the millennium. So where are the productivity benefits? Perhaps the dynamics of modern consumer markets have contributed to a discord between innovation and efficiencies. Or perhaps we have all grown too impatient, and the productivity gains from recent innovations will show up eventually.
Since the end of the financial crisis, most investment assets have grown at a robust clip. Wages, consumer prices and other economic growth measures have lagged. This is not a recipe for sustainable economic success. We should be mindful of how the productivity trend develops – for therein lies the most plausible key to real growth.
We are now one third of the way into 2015. What can we say about the state of things in the capital markets? US equities would appear to merit little more than “meh”. The S&P 500 saw out the month of April with a 1 percent drop and the Nasdaq pulled back 1.6 percent. As the chart below shows, stocks have spent most of the year so far alternatively bouncing off support and resistance levels. The longest breakout trend so far was the rally that started and ended almost precisely within the calendar confines of February. A directional move one way or the other will eventually happen, but the sluggish current conditions could persist for some time yet.
Unenthusiastic and Confused
If one could attribute human characteristics to the stock market, Mr. or Ms. Market would merit the sobriquets “unenthusiastic” and “confused”. These two attributes derive from already-expensive valuation levels, uninspiring company earnings, and a muddied picture of the overall economy in the wake of some recent soft headline numbers. At 17.0 times next twelve months (NTM) earnings, the S&P 500 is considerably more expensive than it was at the peak of the 2003-07 bull market, when the NTM P/E failed to breach 16 times. At the beginning of 2012 the NTM P/E was 11.6 times. After three years of multiple-busting expansion, investors’ current lack of conviction would hardly seem irrational.
Earnings: Clearing a Very Low Bar
This brings us to earnings. Expectations were grim as the Q1 earnings season got under way, with analysts forecasting negative growth in the neighborhood of -4 percent. That appears to have been a rather exaggerated take on the impact of the dollar, oil prices and other factors on earnings. With 72 percent of S&P 500 companies reporting, earnings per share (EPS) growth is 2.2 percent. The current consensus is for EPS growth to be more or less flat year-on-year when the results are all in (40 percent of energy companies have not yet posted, and their contribution will be largely negative). But zero percent growth, even if better than expectations, is not euphoria-inducing. The current EPS growth consensus for the full year is 1.5 percent. That’s roughly equal to the S&P 500’s price appreciation for the year to date, which may help to explain the stickiness of the current resistance levels.
Growth or No Growth?
Finally, an increasingly mixed picture of the US economy is stumping pundits and Fed governors alike. The Q1 GDP numbers released this week add another data point to the case for weak growth, joining the March jobs numbers, a string of below-trend retail sales figures, a downtick in consumer confidence, and soft manufacturing data. The question is whether this is merely a repeat of 2014 or something more enduring. Last year, an unusually cold winter helped drive negative Q1 GDP growth, but the economy snapped back nicely to grow at an average rate of 4.8 percent over the ensuing two quarters. Such was the gist of the Fed’s post-FOMC message this week: let’s wait and see what happens once the effects of winter and West Coast port problems are removed from the equation.
Since Q2 GDP will not be known before the Fed’s June conclave, we see almost no likelihood of any action on rates coming out of that meeting. That in turn will keep markets guessing for longer – potentially prolonging the duration of this uninspired “meh” market.