Let the wailing and gnashing of teeth begin: the stock market is down almost 5% from the highs!
It was once the case that investors viewed equity market volatility with aplomb. When you could only check your stock prices daily in the paper, and when people were cautious and unlevered because they recognized that crazy things sometimes happened and they couldn't count on the central bank to bail them out, a 5% setback was just part of the normal zigs and zags. But now we see the VIX rising into the high teens, and a bid developing in Treasuries.
The bid, however, is not as apparent in TIPS. Investors irrationally consider TIPS a "risk-on" asset, even though they are safer than Treasuries since they pay in real dollars. It's a wonderful thing, because every time there is a market upset "risk-off" trade, TIPS and/or breakevens start to offer terrific value and instead of losing when the panic passes, as with normal Treasuries that slide back down when the flight-to-quality passes, TIPS valuations will snap back. In the meantime, they offer hard-to-miss entry points. For example, right now the 10-year breakeven is at 2.19%, which means expectations are that the Fed will miss its 2% target on PCE on the low side over the next ten years (since PCE is regularly around 0.25%-0.5% below CPI).
Even if that happens, the Fed surely will not miss it by very much (in that direction) - in the worst recession of our lifetimes; core CPI printed 1.8% for 2009, 0.8% for 2010, 2.2% for 2011, and 1.9% for 2012. Headline CPI was 2.7%, 1.5%, 3.0%, and 1.7%, so the average for core over the last four years of epic financial disaster has been 1.7% and for headline, 2.2%. So why in the world would someone buy a 10-year Treasury note at 2.09% when they can own 10-year TIPS for -0.10% + inflation? There seems to me to be mostly downside to holding nominal bonds relative to TIPS…but investors will consistently make this error, and it may get worse, if stocks continue to correct.
However, that error will not last for long, I suspect. CPI will be released on June 17th, and I expect everyone will expect a very soft core inflation number. I believe the housing part of inflation will start to heat up as soon as this month, and I would be very surprised to see inflation print below what will surely be very soft expectations. If core inflation prints 0.3%, rather than last month's 0.1%, the market will be completely the other way.
That's not the near-term concern, though. Near-term, investors are concerned that the weak economic growth we have seen for the last several years rolls over rather than continuing to accelerate. The weak ISM print on Monday (the first below 50 since 2009) and today's modest downward surprise in the ADP employment number (135k new jobs, the weakest since September) has increased nervousness that a stock market which is currently trading at nearly 23 times 10-year earnings, in an environment of record gross margins, might not be able to handle an environment that is less than perfect. I don't blame investors for that concern.
Another concern, which oddly seems to be vying for equal time, is that the Fed "sounds serious" about ceasing its program of securities purchases. I am highly doubtful that both the weak growth and the end-of-QE concerns can both come to fruition, but even if growth continued to bump along at soft, but not recession levels, I doubt the Fed would be cutting QE very soon. The Fed speakers who "sound serious" about reining in QE are mostly established hawks like Dallas Fed President Richard Fisher, who said on Tuesday that "we cannot live in fear that gee whiz, the market is going to be unhappy that we are not giving them more monetary cocaine." Against that, set the people whose votes actually matter: Fed chief Ben Bernanke, who evinces few concerns that there's anything negative about QE and so isn't in any particular hurry to stop it. And William Dudley, who said recently that it will be a few months before the Fed can even decide on a tapering strategy (which would presumably have to precede an actual taper). I side with Fisher on this one, but my vote counts just about as much as Mr. Fisher's.
(However, I can't wait to see what my friend Andy at fxpoetry.com does with the cocaine comment tomorrow).
My view has not changed much: I think growth is going to be slow, but we're probably not going to slip back into recession although we are technically due for one by the calendar. I think inflation is going to rise, and keep rising, and I think the Fed will be very slow to stop QE. Even once it stops QE, it will be slow to remove the accommodation, and inflation will continue to accelerate while it does so. I think stocks are overvalued and offer very poor real returns going forward. I do think that TIPS are now a much better deal than Treasuries, and not a bad deal on an outright basis relative to equities - the first time in a while I could have said that. In fact, the expected 10-year real return on equities is less than 2% more than the expected 10-year real return on TIPS (the latter of which has no risk), which is the worst valuation for stocks relative to TIPS since August of 2011.
In fact, here's a fact which is worth dwelling on for any investor who says that stocks are a good deal because nominal interest rates are low. Stocks, of course, are real assets (although they tend to do poorly in inflationary periods, as I have said), and if you want to compare them to an interest rate you ought to be comparing them to a real interest rate rather than a nominal interest rate. So, let's do that. The chart below (Source: Bloomberg) shows the 10-year TIPS yield (in yellow, inverted) plotted against the S&P 500 for the period I just mentioned.
I think the conclusions are likely obvious. The last time real yields were at these levels, the S&P was between 1200 and 1400 (if you want to be generous about the early-2012 example). It's over 1600 now.