Babies and Bathwater
Before I descend into the mundane discussion of economies and markets, let me first congratulate the Duke and Duchess of Cambridge on the birth of their son. In watching the pictures of the royals leaving the hospital with their child, I was struck at the fact that when his wife passes off the child, Prince William looks as uncomfortable holding a baby as most first-time fathers are. He did, however, have more luck with the mechanics of the car seat…as, again, most new fathers do.
However, when he drives home, he won’t have to worry about the rising cost of housing, and probably doesn’t fret much about whether his child will be able to afford a comfortable life in an inflationary future. “Will my son be better off than I am?” is a question for non-royals!
I have no idea what the rents are for a Kensington Palace apartment, but I will bet they are rent-controlled. Meanwhile, housing prices in the U.S. continue to rise rapidly. Today’s announcement of the FHA Home Price Index suggested prices have risen 7.3% over the last year (the fourth month in a row over 7%), while the median price of a home in the Existing Home Sales report yesterday was 13.2% above the year-ago level (see chart).
Aside from inflation, however, where the future trajectory is clear, the performance of the economy is probably best characterized by the word “muddled” (thank you, John Mauldin). Last Thursday, the Philly Fed index was published at 19.8 – a two-year high – versus expectations for 8.0; on Monday the Chicago Fed index showed -0.13 versus expectations for flat, and today the Richmond Fed index was -11 (the second-worst since 2009) versus expectations for +9.
And, in the meantime, Microsoft (MSFT) and Google (GOOG) missed earnings badly and Detroit declared bankruptcy. Apple (AAPL) is just out with earnings and pulled the old trick of “beat on current earnings, match on revenues, but guide lower for next quarter.” The current consensus for Q2 GDP (the advance estimate is due out next week) is a mere 1.3%.
With all of this, equity prices are doing well with stocks up 5.4% for the month. Bond yields are fairly flat, with 10-year yields up 4bps from the end of June, but TIPS are doing relatively well (10y real yields -14bps; 10y breakevens +18bps). And even the DJ-UBS Commodity index is +4.3%. Gold is up nearly 10%.
Three weeks do not a turn in sentiment make, but I do find it interesting that real estate, inflation breakevens, gold, and commodities generally are all enjoying a renaissance right after inflation-linked bonds and commodities were buried in late June, with large outflows especially from TIPS funds (the shares outstanding of the TIP ETF went from 183 million at year-end, to 165 million in late May, to just 139 million now). It got so bad that my company reached out to customers in late June with a thorough explanation and presentation of why we thought the market was ‘getting it wrong.” Investors were throwing out the baby with the bathwater.
To be sure, I think real yields, breakevens, and nominal yields will eventually be much higher. But if nominal yields can simply avoid breaking higher for the next few weeks, I think the stage will be set for a fixed-income rally into September and October. As I have written before, in the aftermath of a convexity event such as we have just seen, a “cool down” period of a few weeks is usually necessary to work off the bad positions induced and trapped by the market’s sudden slide. Once these positions are worked off, I think the weak economic growth and weakening corporate internals will pressure stocks lower and the stock and bond markets will get back into some semblance of what static-equilibrium types think of as “fair value” relative to one another.
Even so, I think that commodities, breakevens, and even gold might have already seen the worst of their markets. In this suspicion I have been wrong before. Money velocity in Q2 will have declined further (probably to about 1.50 from 1.53 in Q1), but I think it will be higher – or at least not much lower – in Q3. And once velocity turns, time has run out. I am reminded of an old quote from Milton Friedman, from his book Money Mischief: Episodes in Monetary History.
“When the helicopter starts dropping money in a steady stream – or, more generally, when the quantity of money starts unexpectedly to rise more rapidly – it takes time for people to catch on to what is happening. Initially, they let actual balances exceed long-run desired balances, partly out of inertia; partly because they may take initial price rises as a harbinger of subsequent price declines, an anticipation that raises desired balances; and partly because the initial impact of increased money balances may be on output rather than on prices, which further raises desired balances. Then, as people catch on, prices must for a time rise even more rapidly, to undo an initial increase in real balances as well as to produce a long-run decline.” (p.36)
When this happens, stocks will take a beating. But it may be the final beating in this long, drawn out, secular bear. I guess it is far too early to say that, but I recently saw two news items that I have long been waiting for. The first is that CNBC is having ratings “issues,” and it is starting to get bad enough that the producers are thinking about “tinkering with primetime.” The second, which is clearly related, is that Maria Bartriromo is thinking of leaving business news to take her inestimable talents elsewhere.
As with commodities and inflation breakevens recently, a sine qua non for the start of a new bull market of substantial magnitude – not a 100% rally from the lows, but a 100% rally above the old highs – is that everyone stops thinking that stocks are smart and exciting investments, that they are “where it’s at,” and that all the cool people are buying stocks. And I have never been able to figure out how an environment sufficiently depressing to germinate a new bull market can occur if the cheerleaders are televised 24/7. Honestly, I had just about given up. While we still need cheap valuations and rotten sentiment to start a bull market (and we are very far from both of those standards in equities), a move towards general indifference among investors would be a good start.
 As the quote marks suggest, I don’t think that they will be right when you hear people declare that “stocks now offer good value relative to bonds again.” I think the people who use the “Fed model” tend to overprice stocks generally…and they tend to be much more diligent disciples of the model when yields are falling than when they are rising. When yields rise, they tend to say that stocks are better values than bonds because bond yields are going to rise, while when yields are low they tend to say that stocks are better values than bonds because of the current level of bond yields.