In a world of fragile economic growth where the odds of recession have been on the rise, investors are now convinced that central banks (CBs), led by the Fed, have their backs, as they see the CBs as “buyers of last resort.” Note that the Fed, whose legislative mandates are low unemployment and stable prices, has morphed into the role of equity market savior beginning in the Greenspan era and rolling forward.
The world is deflationary because technology and demographics have produced excess capacity. Until recently, the CBs, led by the Fed, have been on a mission to “normalize” interest rates and, in the Fed’s case, its balance sheet. But now that mission has been aborted, and the Fed and the other CBs have moved toward the “easy” button. Because equity investors believe that the CBs will be successful and/or will step in to purchase assets if prices fall, equity prices continue to rise. On the other hand, bond investors have ferreted out the deflation issue and have pushed bond yields down (prices up), in effect, forcing the CBs to follow.
Because the CBs have now become the “buyers of last resort,” they can never sell, because, if they do, everyone will sell. What a disaster that would be! It is hard to believe, but we are apparently stuck with $13.5 trillion of debt with negative yields. In this bizarre world, here are some examples of 10-year yields from high quality borrowers:
· Germany: -0.40%
· France: -0.14%
· Sweden: -0.12%
· Switzerland: -0.74%
· Netherlands: -0.27%
· Japan: -0.16%
Now, look at this anomaly – lower quality 10-year debt carrying lower yields than higher quality:
· U.S Treasury (AAA): 2.05%
· Greece (B+): 1.96%
· Spain (A-): 0.31%
· Portugal (BBB): 0.38%
If the CBs were in selling mode, what investor, in his/her right mind, would own a negative yield? There wouldn’t be any buyers! And who, even in today’s market, would want to own Greek, Spanish, or Portuguese debt when a much better quality choice exists at a much higher yield? The only ones that do are those that must by law or regulation, and the European Central Bank. (Note that the Bank of Japan, too, owns a significant portion of the entire Japanese economy!)
In this confused landscape, there is no such thing as “intrinsic value.” To play in today’s equity market, one must follow the momentum, and hope that, if there even is an exit signal, one will be smart enough and bold enough to follow it.
The real GDP growth rate for Q2 (+2.1%) was slightly stronger than market expectations, and, on the surface, played into the “economy is strong” theme. Disaggregating it into components, however, tells a different story:
· Government spending jumped at a 5% annual rate, the largest increase since Q2/09 when the economy was in a crisis;
· Real consumer expenditures rose at a 4.3% annual rate, but that was partly due to a reduction in the savings rate by -0.4 pct. points and by significant additions to credit outstanding;
· The rest of the economy, basically the business side (capex, construction, housing, inventories, net exports) contracted at a -12% rate. In the normal course, business contraction is followed by rising unemployment and then by a consumer pull-back;
· Finally, something no one is talking about, there were significant downward revisions to 2018 GDP: Q2: 3.5% vs. 4.2%; Q3: 2.9% vs. 3.4%; Q4: 1.1% vs. 2.2%, and to 2017 and 2018 corporate profits.
· It is the Wall Street game – lower expectations so most companies “beat.” And, that is what is currently happening. Nevertheless, in comparison to a year earlier, earnings growth in Q2 will be lower by about -2.5%;
· Despite falling mortgage rates, the housing market continues to be underwhelming. New Home Sales were up slightly in June (646k annualized vs. 604k in May – consensus was 658k), but spec buying represented 34% of these sales. The specs are large buyers wanting rental units (the millennial issue);
· The Cass Freight index was -3.8% in June vs. May and -5.3% vs. a year earlier with declines now for seven months in a row. Through June 30, railroad car loadings are off -2.9%;
· Germany’s manufacturing PMI: 43.1; France: 49.9; the Euro area: 46.4 (negative for six months in a row and the lowest since 12/12);
· A hard Brexit seems likely now that Boris Johnson is the U.K’s PM;
· U.S. manufacturing PMI: July 50.0 (49.981 to the third decimal indicating contraction) vs. 50.6 (consensus 51.0). This is the lowest print since 9/09; output, employment and backlogs are all in contraction;
· U.S. Imports fell -0.9% in June vs. May and exports were down -0.7%; import prices fell -2.0% from a year earlier, and export prices were down -1.6%;
· The real inflation adjusted average weekly earnings fell at a -1% annual rate in Q2, its first decline since Q2/11; this will have consequences for consumption in Q3 and beyond;
· OECD’s leading indicators have fallen for 17 months in a row.
Growth in the world and in trade has slowed significantly, to the point of recession or near recession in some parts of the world. China, for example, had its weakest growth rate on record in Q2 (dating back to 1992), and that is via the “official” data. Singapore GDP was a large negative and So. Korea looks soft. The forecasts for economic growth in Mexico and Brazil have been throttled back significantly by the IMF. Then there is the uncertainty of what a hard Brexit will do to both the UK and the EU, parts of which already appear to be in recession. In the U.S., Q2 GDP was weaker than Q1, but in-line or better than expectations.
Investors should be concerned about growth, as further weakening risks recession, especially in light of a weak global economy and downward revisions to U.S. 2018 GDP showing more anemic overall growth and much lower profitability than originally reported. Simultaneous declines in exports, housing, and business spending rarely happen outside the context of recessions. Income is the ultimate driver, and, on that score, the news isn’t good, as real average take home wages aren’t rising much at all. Europe is now in recession, and it looks like U.S. manufacturing is there too.
It should be worrisome that if the U.S. consumer stalls, recession is certain to follow. Meanwhile, investors continue to believe that CBs, who have taken on the role of buyers of last resort, have their backs.
Robert Barone, Ph.D. is a Georgetown educated economist. He is a financial advisor at Four Star Wealth Advisors. www.fourstarwealth.com. He is nationally known for his writings and Robert’s storied career includes his having served as a Professor of Finance, a community bank CEO, and a Director and Chairman of the Federal Home Loan Bank of San Francisco. Robert is currently a Director of CSAA Insurance Company (the AAA brand) where he chairs the Finance and Investment Committee. Robert is the co-portfolio manager of the UVA Unconstrained Medium-Term Fixed Income ETF (FFIU)