Whoever is selling stocks these days is really appreciative of those who are pushing the market higher. Thanks to overnight rallies in China and Japan on Tuesday night, US stocks launched higher at the open on Wednesday. Now, neither the modest rally in Shanghai (led by official buying) and the bigger rally in Japan (on Prime Minister Abe’s pledge to cut corporate taxes next year) had the slightest thing to do with items that impact the US, but the rally led a wave that rolled through futures markets around the globe until about seven minutes after traditional stock trading hours opened in New York, when the high of the day was set. The next six-and-a-half hours saw a 440-point decline in the Dow and around 50 in the S&P to a net loss of about 1.4% on the day.
“Gee, thanks!” said the pension fund guys who got to unload stocks about 3% higher than they otherwise would have. Who says the fast money monkeys don’t have salutatory effects?
The clue that today’s rally was not going to be sustained was actually in the energy markets. Prior equity oscillations had been mirrored with quite reasonable fidelity in the last week or two, but this morning energy markets were noticeably flat-to-down. Equities soon joined them.
Now, yesterday I mentioned that real yields are near their highest levels of the last five years, and that nominal yields are essentially in the middle of that range. I didn’t illustrate the latter point; but see below (source: Bloomberg).
So it is clear, to me, where you would rather place your bets in fixed-income: with real yields around 65bps and nominal yields at 2.20, you only want to own nominal bonds if inflation is less than 1.55% for ten years. Note that if inflation is negative, then you do approximately the same with TIPS as with nominal bonds, since in both cases your nominal principal is preserved. So it is a narrow set of circumstances in which you do better owning nominals, and you don’t do much better. On the other hand, there are long tails on the other side: ways that by owning TIPS you will do dramatically better.
I mention this, even though both nominal bonds and TIPS offer poor prospective returns, because it is the time of year when seasonally it is difficult to lose by owning fixed-income. The chart below (source: Bloomberg) shows the average change in nominal 10-year yields over the course of a calendar year for the last 30 years (gold), 10 years (white), and 5 years (red). Note that this isn’t a pure seasonal chart because it doesn’t correct for the average drift over the course of the year, but it suffices to show that buying bonds after the early-September backup has been a good strategy for many years…really, until the last five years, and even then it was a push between mid-Sep and mid-Nov.
So what I want to do in a period of uncertainty, headed into the fourth quarter, is to own TIPS, either outright or via an ETF like TIP. If the market comes unglued, then all interest rates should decline; if the market drops because real growth is weakening, then real rates should fall more than nominal rates (and in any event, owning TIPS gives you the positive tail exposure I mentioned above). If the market turns around and rallies, then energy probably recovers somewhat and this will help TIPS compared to nominals. But in any event, I am reducing risk into a very risky period.
Let us begin with this: there is nothing inherently healthy about a series of +2% and -2% days within a range.
Having some grey hair (just a little!) is helpful in times like these because markets go through repetitive phases and it helps to have some historical comparisons to be able to guide an investor. At the same time, experience can be limiting if we try to force everything we are seeing into a particular historical comparison.
So, for example, I never view with anything but amusement the charts of day-by-day comparisons between this year’s market action with, say, that of 1929. Or, as another example I have seen: comparing a market to the Nikkei crash in the early 1990s. These are interesting an amusing market parallels, but there is no road map to markets. There is only a contour map.
The contours of this market are reminiscent to me of the end of the tech-led bull market in 2000. The valuation parallels are obvious, but I am not talking about that. In 2000, as the market crested in March and began to head lower, we started to have very large overnight moves – sometimes higher, sometimes lower – followed often by a sharp open, directionless trading during the day, and often a sharp move at the close. This was the signature of fast money, which tends to get more timid during the daylight but which enjoys monkeying about with buy and sell stops overnight. In general, as the market headed lower, it seemed like Mondays tended to be pretty good, and Fridays tended to be pretty bad as no one wanted the weekend risk. There was a lot of volatility, and some spectacular up days. But month after month, the market was more likely to end the month lower than it began.
I think we are in that mode again, although it is hard to tell if we have anything like that kind of bear market ahead of us. Certainly, we can make that point valuation-wise. Also, interest rates have much more room to move higher from here than to move lower. While I think the economy is slowing, and any Fed action is likely to be small, tentative, and probably delayed, my point is that interest rates are not likely to provide a following wind to valuations.
Indeed, while nominal interest rates are still locked near 2% on the 10-year note, real interest rates are near the highest levels in five years (see chart of 10-year real interest rates, source Bloomberg).
The flip side of stable nominal interest rates and rising real rates, of course, is declining inflation expectations. By our calculations, the market is currently implying core inflation to be below the Fed’s target for at least a decade. And this is despite the fact that, measured by median inflation, it is already at target.
I once believed that the Fed could not really control long-term interest rates, although at least in principle they can control Treasury rates like they did in WWII, by simply buying or selling whatever it takes to keep rates at their target (it was easier then, as the market was a lot smaller!). And I guess that, deep in my gut, I still believe that. But I must admit that the evidence that they can control nominal interest rates, at least in normal times (that is, when the weight of the market doesn’t strenuously disagree), is starting to look pretty strong. There is absolutely no rationale for 10-year nominal interest rates at 2% in an environment where real interest rates are 0.65%, current inflation is 2.3%, and there is a large amount of money in circulation – with no plans in place to drain it.
(For anyone claiming a fear of deflation, I just shake my head in disbelief. Choose: Do you want to be a monetarist, in which case you have to construct a case for deflation from 6+% money growth and money velocity that is already at levels below any previously measured; or do you want to be a Keynesian and explain how you get deflation with unemployment at 5.1%? The third way is hand-waving, claiming that large amounts of debt lead mystically to deflation. But large amounts of public debt have never led to deflation in the past, and there is no obvious mechanism for it to do so.)
My reading of the contour map suggests a market valley ahead. It is a deep valley, but the good news is that there is a mountain on the other side of it. There always is.
I may have the lay of the land wrong, but I have been over this ground before. Watch your step.
I really enjoy reading, and listening to, Rob Arnott of Research Affiliates. He is one of those few people – Cliff Asness is another – who is both really smart, in a cutting-edge-research sense, and really connected to the real world of investing. There are only a handful of these sorts of guys, and you want to align yourself with them when you can.
Rob has written and spoken a number of times over the last few years about the investing implications of the toppling of the demographic pyramid in developed markets. He has made the rather compelling point that much of the strong growth of the last half-century in the US can be attributed to the fact that the population as a whole was moving through its peak production years. Thus, if “natural” real growth was something like 2%, then with the demographic dividend we were able to sustain a faster pace, say 3% (I am making up the numbers here for illustration). The unfortunate side of the story is that as the center of gravity of the population, age-wise, gets closer to retirement, this tailwind becomes a headwind. So, for example, he figures that Japan’s sustainable growth rate over the next few decades is probably about zero. And ours is probably considerably less than 2%.
He wrote a piece that appeared this spring in the first quarter’s Conference Proceedings of the CFA Institute, called “Whither Bonds, After the Demographic Dividend?” It is the first time I have seen him tackle the question from the standpoint of a fixed-income investor, as opposed to an equity investor. I find it a compelling read, and strongly recommend it.
Don’t miss the “Question and Answer Session” after the article itself. You would think that someone who sees a demographic time bomb would be in the ‘deflation’ camp, but as I said Rob is a very thoughtful person and he reaches reasonable conclusions that are drawn not from knee-jerk hunches but from analytical insights. So, when asked about whether he sees an inflation problem, or continued disinflation, or deflation over the next five years, he says:
“I am not at all concerned about deflation. Any determined central banker can defeat deflation. All that is needed is a printing press. Japan has proven that. Japan is mired in what could only be described as a near depression, and it still has 1.5% inflation. So, if a central bank prints enough money, it can create inflation in an economy that is near a depression.”
This, more than anything else, explains why keeping interest rates low to avert deflation is a silly policy. If deflation happens, it is a problem that can be solved. Inflation is a much more difficult problem to solve because collapsing the money supply growth rate runs counter to political realities. I don’t think this Fed is worried about inflation at all, and they’re probably not worried too much about deflation either any longer. But they believe they can force growth higher with accommodative monetary policy, when all available evidence suggests they cannot. Moreover, Arnott’s analysis suggests that we are probably already growing at something near to, or even above, the probable maximum sustainable growth rate in this demographic reality.
Maybe we can get Arnott on the Federal Reserve Board? Probably not – no one who is truly qualified for that job would actually want it.
**Note – If you would like to be on the notification list for my new book, What’s Wrong with Money?: The Biggest Bubble of All – and How to Invest with it in Mind to receive an email when the book is published, simply send an email to WWWM@enduringinvestments.com and I will put you on the list!
Below is a summary of my post-CPI tweets. ou can (and should!) follow me @inflation_guy or sign up for email updates to my occasional articles here. Investors with interests in this area be sure to stop by Enduring Investments.
- Core CPI prints +0.145…just misses printing +0.2, which will make it seem weak. We will see the breakdown.
- y/y core goes to 1.73% from 1.81%. A downtick there was very likely because we were dropping off +0.23%
- This decreases odds of Sept Fed hike (I didn’t think likely anyway) but remember we have a couple more cpi prints so don’t exaggerate.
- Core goods (-0.3% from -0.2%) and core services (2.4% from 2.5%) both declined. Again, some of that is base effects.
- fwiw, next few months we drop off from core CPI: +0.137%, +0.098%, +0.052%, and +0.145%. So y/y core will be higher in a few months.
- INteresting was housing declined to 1.9% from 2.2% y/y. But it was all Lodging away from home: 0.96% from 5.1% y/y!
- Gotta tell you I am traveling now and that reminds you the difference between rate and level. Hotels are EXPENSIVE!
- Owners’ Equiv Rent +2.79% from 2.77%. Primary Rents 3.47% unch. So the main housing action is still up. And should continue.
- Remember the number we care about is actually Median CPI, a couple hours from now. That should stay 0.2 and around 2.2% y/y.
- At root, this isn’t a very exciting CPI figure. It helps the doves, but that help will be short-lived. Internals didn’t move much tho.
The last remark sums it up. While the movement in Lodging Away from Home made it briefly look like there was some weakness in housing, I probably would have dismissed that anyway. There’s simply too much momentum in housing prices for there to be anything other than accelerating inflation in that sector. We have a long way to go, I think, before we have any topping in housing inflation.
But overall, this was a fairly boring figure. While the year-on-year core CPI print declined, that was due as I mentioned to base effects: dropping off a curiously strong number from last year. (That said, this month’s core CPI definitely calms things a bit after last month’s upward surprise). However, the next few base effect changes will push y/y core CPI higher. While today’s data will be welcomed by the doves, by the time of the September meeting the momentum in core inflation will be evident and median inflation is likely to be heading higher as well.
Note that I don’t think the Fed tightens in September even with a core CPI at 2% or above, but the bond market will get very scared about that between now and then. Could be some rough sledding for fixed income later in the summer. But not for now!
This week, I am participating in a school-style debate at the Global Fixed Income Institute’s conferences in Madrid where the question before the house is whether or not inflation will resurface in major world economies in the next five years. As you might imagine, I feel that my part of the debate is the easy part, especially as inflation is pointing higher in the US and core inflation just surprised higher in Europe. However, I am sure the other side feels the same way.
The Institute is interested in this discussion partly to illuminate the question of whether the substantial rise in yields over the last three months or so in all developed bond markets (see chart, source Bloomberg, showing 10y yields in US, UK, Germany and Japan) is indicative of a return of fears of inflation.
The ironic part of this is that I do not believe that the rise in yields has much if anything to do with the expectation for higher inflation. Partly, it is due to a subtle sea change in the way investors are thinking about the prospects for central bank policy – to wit, the possibility (which I see as slim) that the Fed chooses to raise rates meaningfully above zero in the next year, starting in September. But to some degree, the market has been discounting higher forward rates for a very long time. It has been consistently wrong on that point, but the steeply sloped yield curve (the 2y/10y spread hasn’t been flatter than 120bps since early 2008 – see chart, source Bloomberg) implies higher forward rates.
The rise in yields, in my view, is partly related to the prospect for changes in central bank policy, but also partly (and more sinisterly) related to the continuing intentional destruction by policymakers of the ability of large banks and dealers to make markets. We see worse liquidity in more and more markets almost by the day (as predicted five years ago in this space, for example here and here, as well as by many other observers). Less liquid markets tend to trade with more volatility, as it gets harder to move institutional size, and at lower prices since holders of assets need to factor in the difficulty of selling a position. Higher yields are going to happen in any event, and when institutional holders of bonds decide to diversify into commodities or into other real assets, interest rates could rise quickly depending how quickly that meme spreads. Of course, the same is true of equities, and commodities. Asset-allocation shifts will get messier.
I actually think this isn’t a bad time tactically to enter long positions in fixed-income. The Fed isn’t going to be as aggressive as people expect; also, bonds will get some support from investors fleeing fading momentum in stocks. The chart below (source: Bloomberg; Enduring Investments calculations) shows the 52-week price change in stocks. This is one measure of momentum, and a very important one as lots of investors look at their returns in annual chunks. Incredibly, since the latter part of 2012 investors have always been able to see double-digit returns from stocks when they looked in the rear-view mirror. Today, that number is 7.5%.
That’s still a terrific real return of more than 5%, but (a) many investors have very screwy return expectations, (b) many investors are well aware that they’ve been living on borrowed time with a liquidity-inspired rally, and (c) certain quantitative investors place significant weight to momentum, over value, in their investment models.
It’s just another red flag for stocks, but it has become passé to point them out. From the standpoint of a bond investor, though, this is good news because all of those equity owners, when they decide to take their chips off the table, will become bond buyers.
And when that happens, the liquidity issues in fixed-income might cut the other way for a while.
Two relatively quick items that I want to address today; they have been in my ‘to do’ box for a while.
One of the most interesting features of the fixed-income landscape today, and one that will likely serve in the future as an exam question on finance quizzes, is the increasingly widespread proliferation of negative nominal interest rates among government bond markets…and occasionally even for high-quality corporate paper.
In finance theory, this can’t happen. Because currency earns a 0% nominal interest rate, theory says that no rational person would ever accept a negative nominal interest rate. If I have $50 today, and put it in the bank, I will have $49 tomorrow. So why not just keep the $50 in my wallet? (Obviously this leads to high cash balances, which means low monetary velocity, by the way). And this is true in the absence of “other costs.”
So why are so many interest rates negative? Are individuals irrational? No: at least not so irrational that they prefer less money to more money. However, what is true at an individual level does not necessarily scale to the institutional level. An institution, such as a money fund or corporation, does not have the freedom to hold its assets in physical currency. Microsoft has $90 billion in cash and equivalents. If this were in $100 bills, it would weigh about one thousand tons. That’s a pretty big vault. And vaults cost money. Guards cost money. And, if Microsoft had this money in the vault, it would be harder to spend. It is much easier to wire $5 million than it is to send an armored car.
In the presence of those costs, Microsoft and other institutions will accept a negative interest rate. It will invest its money at a negative rate rather than build a vault.
Now, an important (if obvious) point is that cash balances are so high, and interest rates so low, because global central banks are making sure we have plenty of cash. Too much cash chasing too few investment opportunities causes rates to be low.
Walmart and Minimum Wage Increases
It has been a few weeks now, but when Walmart in February announced it was going to increase the minimum wages it plans to pay its employees (preceded by Starbucks, Aetna, and the Gap and followed by TJX and Target), I received a number of queries about what the hike was going to do to inflation. Is this the beginning of the much-feared “cost-push inflation”?
The answer is no. Wages, as I have said many times, follow inflation rather than lead it. Think about it: wouldn’t it be really weird for companies to raise wages and then raise prices, to the extent that they have control – at least with respect to timing – over both? No, whatever price increase is going to be caused by the increase in the wages Walmart expects to pay is already in the price. Walmart is not surprised by their own move to raise wages. Nor is anyone surprised by the general increase in the minimum wage, which happened in 2009.
So, while I continue to believe that inflation is rising, and will continue to rise…I don’t believe that the increase in prices is going to be any faster due to these wage increases. It does, however, increase my confidence that inflation is rising, since obviously these retailers are confident enough in the pricing environment to be able to increase wages (which are sticky – it is harder to lower them than to raise them).
As we tick towards the end of the quarter, the news feeds are starting to look like they occasionally do when we are having a big spike in volatility.
We have the Greece deadline coming up. I don’t think anyone knows exactly when Greece’s finances will hit the wall, but it is going to be soon. And, compared with prior incarnations of this exact same crisis, there doesn’t seem to be nearly as much optimism about the probability of a “positive” resolution to this crisis. By “positive,” I mean in the sense that the status quo remains more or less preserved: Greece gets money, and pledges reforms, but nothing actually happens except that Greece’s depression continues. I don’t at all mean positive from the standpoint of the Greeks (I continue to think they will be better off in the medium-term to exit the Eurozone and default on Euro-denominated debt), or even from the standpoint of the Euro (assuming the single currency survives, the departure of Greece will be an important test case for the ramifications of re-shaping the currency bloc to a sturdier subset of countries that intend to move towards fiscal union). Interestingly, and in contrast to prior iterations of the exact same crisis, both sides appear to understand that Grexit does not mean disaster, and to perceive the possibility that it might make sense to let this happen – since, in any event, it is inevitable. There seems to be little urgency to craft a real deal, and the panicky increase in market volatility is missing this time.
The Middle East is increasingly in flames. What I call the “black I’s” of Iran, Iraq, and ISIS are as unstable as ever, but now Yemen is in civil war with the existing government fighting Iranian-backed rebels and today Saudi Arabia plunged into the fight as a counterweight to Iran’s influence. The comments that this should be only a short-term influence on crude oil prices because “the market remains oversupplied” make two assumptions that are possibly questionable here.
One is the technical point that the oil market is oversupplied (true), but that this means current prices should not react to disruptions to future supply. Of course, that is wrong: if it was suddenly discovered that all oil in the world was scheduled to evaporate on January 1st, 2020, you can bet your bottom petrodollar that prices today would (and should) react, even though that date is far in the future. Efficient markets reflect not only spot supply and demand, but also discount expectations for future changes in supply and demand (at least, for commodities that are storable at a reasonable cost).
The second assumption that may be questionable is whether the battle over Yemen is just a skirmish over a country with a small oil production footprint. Indeed, that may be the case. However, the appearance of Saudi Arabia into the fray does make one wonder whether the Saudi Kingdom does see a bigger conflict at play here. To the extent that Yemen is an opportunity for Sunnis (most of the Arab world) and Shia (Iran, most of Iraq) to engage indirectly, it signals rising structural tensions in the region and the possibility for much wider conflict. An analogy might be the Cold War phenomenon of the US and the USSR engaging in conflict by proxy; that conflict never emerged into a hot war but that didn’t make those of us hiding under our desks any more confident in the stability of the situation.
I don’t have a strong opinion on whether either assumption is warranted, but it strikes me that markets for implied volatility ought to be somewhat more bid on either possibility, not to mention what is happening in Greece. And yet, they’re not. The two charts below (source: Bloomberg) show the VIX and the MOVE (for bonds). Neither seems to be displaying much alarm at this point. It feels like we should be having a spike in volatility, but we are not. To me, this makes the buying of protective puts an attractive alternative to consider.