If you had only looked at the stock market last week, you might be tempted to think the economic picture had really brightened last week. You might have been mistaken. Everywhere we looked we saw more signs of a global slowdown. How to square the stock market’s nearly 5% gain with the dismal macro numbers? That will be the subject of this week’s article.
Perspective
Stocks: All of the major U.S. stock indexes recorded gains of 4 to 6% last week, led by small caps and tech. Sector action was the reverse of the previous weeks, as the defensive sectors lagged while the growth oriented sectors led, but all finished with solid gains. All but one of the Dow Industrials also gained ground, though a number of the gains were rather marginal. Special mention goes to McDonald’s (MCD), which went to a new all time high. Major foreign indexes were also up across the board, with the exception of Bombay’s Sensex 30. Not a bad week at all for global equities.
Bonds: Treasury yields stabilized after a four week plunge, with the 10 year finishing at 2.19% and the 30 year at 3.54%. One of the more interesting events in fixed income was the widening spread between Treasuries and corporate bond yields. Yields on the two sectors fell together in the risk aversion that began during the last week of July, but the corporates have since retraced the entire move. High yield corporates actually moved up slightly on the return of the risk trade. TIPs fell back about 1%, and munis advanced fractionally.
Commodities: The CRB Index recorded a third consecutive week of modest gains, but remains just below the primary moving averages. Oil, natural gas, copper, the grains and coffee all advanced, though they all remain well off their highs. The precious metals saw sharp drops in the middle of the week following the hike in gold margin requirements imposed by the CME, but in spite of all the commentary about bursting bubbles, the moves did nothing more than relieve highly overbought conditions, particularly in gold and platinum.
Currencies: The U.S. Dollar index fell to the low end of its recent range between 76 and 73.5. The euro remarkably moved up to just a couple of ticks below $1.45, a near term resistance level. The Swiss Franc fell again, but has only just come back inside the one year trend channel. Yen and Sterling were little changed, while the Aussie and Canadian dollars recovered some lost ground, presumably on strength in energy prices.
Outlook
Normally we go directly into the outlook for the various asset classes in the coming week, but for this article we depart from that format slightly to consider the macro backdrop. No doubt most readers are aware of the U.S. Q2 GDP growth number coming in at 1%, after a reading of 0.4% for Q1. This shows the economy close to “stall speed” and at serious risk of falling back into recession. Parsing the BEA release shows that non-financial corporate profits were up a robust 8.5%, and balance of trade improved, so it’s not all negative. However financial sector profits, non-defense federal spending, and state and local governments were a drag on growth, and the consumer remains moribund.
What some may have missed was the discouraging data coming from other quarters. The U.K. Office for National Statistics confirmed its initial Q2 GDP figure of a dismal 0.2%, as austerity budgets begin to go into force. The Brazilian government trimmed its growth outlook, and forecasters lowered GDP estimates for fellow commodity exporters Canada and South Africa. We had already seen the German Q2 number come in at 0.1% the prior week.
Of course, there was extensive coverage of the Jackson Hole symposium, with intense focus on the Fed Chairman’s speech. There are many analyses out there, so we won’t add to it here. For me, it is summarized in two sentences: “The Committee ... is prepared to employ its tools as appropriate to promote a stronger economic recovery” and “most of the economic policies that support robust economic growth in the long run are outside the province of the central bank.” Taken together, the chairman is telling U.S. he still has some monetary easing capabilities at his disposal, but they aren’t going to be decisive in turning this economy around. That is up to fiscal policy makers, who thus far have shown no ability or inclination to get the job done.
In what may be the most significant development of all at Jackson Hole, newly installed IMF chief Christine Lagarde followed the customarily reserved presentation of her countryman, ECB president Jean Claude Trichet, with a number of candid remarks that only confirm the troubling financial and economic situation in Europe. Lagarde called for the forcible recapitalization of banks, and is quoted by Reuters as saying “This is key to cutting the chains of contagion. If it is not addressed, we could easily see the further spread of economic weakness to core countries, or even a debilitating liquidity crisis.” This is not news to those of U.S. who have been following the situation, but there can no longer be any pretense that the crisis is well contained.
Stocks: Now that we have set the macro backdrop, let’s turn to the prospects for equities. We see that earnings outside the financial sector are still very respectable, but the market has begun a process of re-pricing stocks for lower growth - and possibly recession. Although last week’s trading seemed encouraging, perhaps on hopes of renewed monetary stimulus from the Fed, this seems dubious at best. M2 has spiked since the end of QE2 (i.e., since the Fed’s balance sheet stopped expanding). Clearly, liquidity is not a constraint - except in the case of essentially insolvent European financial institutions which are frozen out of the markets (1 month and 3 month U.S. dollar LIBOR have also begun to spike) - so more liquidity can’t be the solution.
Where does this leave U.S. with regard to equities? In my view, the macro environment is unfavorable, so my bias with regard to evidence has flipped. Typically, I maintain a normal allocation to equities unless market conditions tell me to reduce positions. Currently, I maintain a very underweight allocation until market conditions tell me to get back in. What kind of evidence are we talking about? In the near term, an upside break above 1225 on the SPX with good volume would have me dipping a toe in the water. To be fully invested in equities, a move above 1350 certainly would do it.
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Bonds: The Treasury market has already priced in an ugly macro landscape. If the speculation that one of the Fed’s next moves will be to extend the maturities it holds turns out to be correct, there still may be some room to front run the Fed by buying the long bond. This is something I am considering myself, despite an almost visceral aversion to buying 30 year paper yielding 3.5%. Yes, I know plenty of blue chip common stocks have a better yield and a vastly better long term upside but, in a renewed bear market, don’t think for a moment that some of these stocks can’t take a 20% - 30% haircut.
As mentioned above, the big news in bonds is the break in investment grade corporate paper. This is disturbing, particularly as corporate bonds in a range of grades are the largest part of our income portfolio, but I think it’s probably a passing phase. Corporate balance sheets are still flush with cash, earnings prospects are ample for debt coverage and, except for the lower grades and perhaps some financials, credit risk doesn’t seem significantly higher even with economic headwinds. We’re sitting tight, but monitoring the situation closely.<.p>
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Commodities: If we accept the low growth/recession thesis, this is a group of assets that is defying gravity. The extent of the slowdown suggests a lower trajectory of demand growth, but prices don’t reflect that outlook. Look to oil to lead the way. Several of the commodities have held up better in terms of price, but oil is going to move the market, especially for those investors who are using broad basket commodity funds as part of their asset allocation. We have seen a pattern of lower highs and lower lows in WTI since May; there is support at $80 going back more than one year, but a decisive break below that level will be a bearish signal for commodities in general. As for gold, the talk of a bubble bursting and much lower prices to come seems overwrought. It may happen, but we will need to see much more extensive price destruction than what we have seen to date.
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Currencies: The U.S. dollar seemed to come under pressure after Chairman Bernanke’s Friday speech, even though no new monetary easing program was even vaguely suggested. It seems that the mere scheduling of an extra day in September to discuss the available options was enough to do the trick. Meanwhile, if commodities are defying gravity, the euro is having a Wile E Coyote moment. With Lagarde and Trichet seemingly at odds, we will have to see how events unfold next week. Look for the ill considered ECB rate hikes to be rescinded. It’s difficult to imagine going wrong by shorting the euro, the only question being how long it will take to play out.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
