If one looks at consumer sentiment vs the major US indices over a very long period of time, they will notice that they are correlated. That is until recently. The chart below depicts divergence unlike anything we have seen before.
As is clear from the chart, consumer sentiment has dropped like a rock while the Wilshire total market cap index is at a record high.
So, the question is, who is wrong? Are consumers wrong and sentiment will soon come back with a roar to coincide with the market? Or will US markets correct to come to terms with consumer sentiment?
Sentiment should be higher today if one takes into consideration the low unemployment rate, voluntary job quits, high savings and record consumer net worth. All these should have reflected a much rosier sentiment picture, but they haven’t.
The bottom line is that many strange things have happened during this economic cycle. The divergence we are seeing in consumer sentiment vs the market is one of them. Whether this divergence means anything insofar as markets are concerned is unclear. At least for now markets are shrugging it off. Nevertheless, it is an interesting revelation and something to keep an eye on.
The chart below comes to us from the IMF. In short, it is depicting the supply chain turmoil around the world and how it is impacting delivery times. A reading above 50 indicates faster delivery times and a reading below 50, slower delivery times.
This partially explains the higher inflation we are witnessing. How so? Well, supply chain bottlenecks and thus slower delivery of goods have always been associated with higher inflation. One example is the oil crisis of the 70s, that was responsible for higher energy prices ,and higher inflation.
However, supply chain bottlenecks don’t last forever. At some point a return to normality and a reading at around 50 will return. Put in another way, at some point supply and demand will once again find balance.
In fact, what some economists are worrying about is that in the next 12 months we might have much more supply than demand. This because, today we have pent up demand and supply constraints. But with so much pull forward demand, when balance returns, we might find ourselves with more supply than demand. Obviously it’s still early to tell what will happen, but it is something that we are following very closely.
But don’t expect all inflation components to find themselves at pre COVID levels. Wages for example are not expected to fall. However, that is probably a good thing for most people than anything else.
The bottom line is that yes inflation is higher and might be with us for a while, however it’s difficult to see the inflation of the 70s return anytime soon. And while many can blame Central Bank policies for the current inflationary pressures, at the end of the day the main culprit is supply chain bottlenecks than anything else.
While on the surface it seems that markets are doing just fine, there has been a lot of damage done when looking under the surface of the major indices. To begin with, the S&P 500 is not the 500 anymore, but more like the S&P 7. This because the first 7 largest companies of the index comprise over 30% of the market cap of the index. And when we go to the top 50 companies, the market cap is over 50%. This means that while these companies might have double digit gains in many cases, the rest of the market (the other 450 stocks) might be down, and in many cases by a lot.
One chart that is interesting is the number of stocks above their 200 day moving average.
As you can see from the chart, that number is about 62% and falling. In fact, this despite indices being at record high. Almost all breath indicators that I look at are at their low for the year, which generally is not a good thing. But an even more indicative chart of the situation is the highly talked about ARK innovation ETF.
Not only is it down for the year, but it is also down about 30% from its highs of mid-February, which is where most stocks peaked for the year. Yes, there are many opportunities in this market, this because many stocks have been beaten down to scrap levels. At the same time however, it seems that we are entering a risk off faze, judging by the breath indicators that I see.
The bottom-line is don’t judge a market by its major indices, because many times what is actually going on, is not indicative of what the indices tell us.
Inflation: The greatest enigma going forward
The biggest enigma over the next several quarters and, and perhaps years, will be inflation. In fact, weather we are talking about short term or long-term inflation, it’s the issue market participants will be required to wrestle with most.
Listening to analysts and pundits there is no agreement as to the inflation endgame. The debate on both sides is fierce, and both parties have convincing arguments. Central Bankers insist it is transitory, and so far, the bond market seems to agree (mostly).
However please note that dealing with inflation is something new to most market participants, especially fund managers. It has been several decades since fund managers had to deal with inflation, and very few of those that did, still manage money.
Central Bank policy still in focus
Monetary tightening sems to be on everyone’s mind. And while this tightening is still very vague, everyone agrees it will happen in some form. Initially at least, some form of tapering will happen (or so they say) and further on, we will get rate hikes.
Even assuming all the above happen, what is very different this time around is that negative real rates will still be with us (nominal rates adjusted for inflation). As such, this is not a typical economic rebound that we are used to. As such, investors need to adjust to a new reality, and that is one where yields will not rise by much in the face of an economic snapback.
Irrespective of what inflation does, there isn’t much Central Banks can do about it
If you recall, several years ago the Fed tried to raise rates in the name of inflation expectations. It did so to the tune of 2.5% and the U.S. economy and markets collapsed. So, if the economy was not able to withstand interest rates of 2.5% back then, how are today’s economies going to withstand the increase in interest rates needed to combat today’s inflation? The answer is they will not be able to. The US, Europe, and Japan cannot operate in a high interest rate environment. The main reason is that a significant rise will cause havoc for government budgets, debt to GDP metrics, and in most cases higher rates will trigger a recession.
In other words, even if we assume raising interest rates is the solution to fight inflation (a view that I do not subscribe to), it is impossible to raise interest rates to levels needed to fight today’s inflation headline numbers.
So, while Central Banks talk about tapering and higher rates (AKA normalization of policy), I am personally talking the rate hike talk with a huge amount of salt. This because economies will crash and burn with much higher rates, and that is not a Central Bank mandate in any country.
A long list of things to worry about
1. Economies are more leveraged today than they were just several years ago.
2. Individuals, companies, and governments have much more debt that needs to be serviced.
3. Markets have a much higher multiple than almost any time in the past.
4. Real estate prices are elevated all over the world.
5. Economies are snaping back, but there has been a lot of pull forward demand
6. Concerns about growth in China
7. A higher Dollar is bad for global growth
The big risk to economies and markets are higher rates. If we do see much higher rates, all my above worries will be triggered, and the outcome will be brutal. Central Bankers know this, which is why they are being vague about normalizing monetary policy, and refrain from saying when rates will “takeoff”.
Please note that while inflation is a concern, a collapsing economy and a bear market in equities is the lesser of two evils. As such, Central Banks will probably do more talking than acting when it comes to rates. Central Banks know all too well higher rates will do a lot of harm to economies and markets. And personally, I just don’t think this is what they have in mind.
So Central Banks will continue to assure markets they are committed to fighting inflation, but it will not act upon these commitments. But even if we assume Central Banks raise interest rates substantially to alleviate inflation concerns, they will probably lose.
So, what should investors do?
Overall, economies are still growing fast with fiscal and monetary policies still supportive for risk assets. However, investors must not be complacent. There are far too many things that could derail the current global economic recovery. There are still many potholes on the equity yellow-brick road.
My two biggest concerns are elevated equity valuations (especially the US), and the strengthening dollar. Especially insofar as the later, a stronger dollar means that there is either a dollar deficit in the world, or investors are buying dollars as a safe-haven trade. In both cases this is not good for equities.
However, to the extent that Central Banks don’t make a major policy mistake – like tightening too fast, or more than needed – equity markets should continue to offer better returns than bonds. It’s also important to remember that diversification is very important in this environment. Investors need to diversify across asset classes, geography, and sectors.
Finally, we have headline scares out of China. Earlier this week markets were spooked about the possible default of the world’s most indebted developer, which is none other China’s Evergrande Group.
Usually, what happens in China stays in China and has no consequences outside of China. This because China is mostly a closed economy and very rarely anything that happens affects anyone else. Except for exporting a little deflation, which is mostly a good thing.
And given that there will probably be a domestic policy response from the Chinese government (as everyone thinks), any implications within China will also probably be limited.
For some strange reason what applies in western economies does not apply to China. The housing bubble in China has been ongoing for many years now, with analysts and economists forecasting a crash, but no crash ever occurred. Even Hong Kong’s real estate market has been an ongoing bubble for the past 20 years or so, but still no crash.
Yet it is terrifying when one looks at just how expensive real estate in China is, and the implications of a possible nonorderly Evergrande default.
The chart below comes from Nordea and depicts housing affordability in China.
The latest data show that the ratio of the median house price to income in Beijing is about 25, about 13 in all of China, and about 21 for Hong Kong. During the US housing bubble in 2008 this ratio was about 7-8.
So, while everyone expects the Chinese government to mediate and somehow solve the problem, one must ask themselves if it is different this time? Especially if government mediation does not happen or, does not happen enough.
The entire construction sector, including commodities like iron, copper, and cement will be impacted. Many products and services that go into construction, like elevators, will also be hit. Consumer behavior will also be impacted as well. And while local banking issues could be managed, and will have no global impact, Chinese consumer behavior will. The consumer in China is simply too big to be ignored, even by many US companies.
So, getting back to the question if an Evergrande default can have global spillover effects, the answer is probably yes, if the unwinding is not orderly. But even with no spillover, the wall of worry of the Chinese housing bubble will continue to be with us.
Assuming the FED and ECB are wrong, and inflation persists, the question is, what should the investment strategy be in such an environment.
The answer is not as simple as it sounds because current generation of fund managers have no experience dealing with inflation. Reason being, above average inflation has not been around for several decades.
But there is also another reason why dealing with inflation today is an enigma. Several decades ago fund managers sold equities and went into fixed income that had a yield. Today fixed income does not offer any yield. Simply put, there is no money to be made in bonds anymore, outside of trading them and hoping to make capital gains. According to Bank of America Corp, about 25% of all global bonds yield below zero, and only about 1/3 of all fixed income yields above 1%. In fact, negative real yields have even been sighted in European junk debt.
So, the question of how to navigate an inflationary environment is not an easy one. This because no matter what the inflation outcome is, yields are not expected to be what they were 40 years ago. The only place to find respectable yields is in emerging market sovereign debt, or high risk plays such as China Evergrande Group, which had a coupon ranging from 8%-12%, but now bondholders face as much as an 80% haircut.
The bottom line is, assuming inflation persists, this is a very difficult and challenging environment to navigate. On the one hand we just don’t know how the market will react, and on the other, bonds are yielding close to zero. Having said all this, I don’t think equities will correct even if inflation persists. If we do see a major correction in equities, it will most likely be because of valuation concerns coupled with another COVID scare than anything else.
The chart below depicts the price of sugar. As you can see, prices today are lower than what they have been in many instances from 1970. And why are sugar prices so low? Because the people who produce sugar have become more productive at it, thus the unit cost of production has fallen, and producers can still make money.
So why has all the monetary stimulus not pushed up the price of sugar much higher, as is conventional thinking? The answer is because commodity prices are supply and demand driven.
When we look at gold, which is supposed to be a hedge against inflation and monetary expansion, it is where it was about 10 years ago. And if we look at platinum, it is less than half of where it was a little over a decade ago.
In fact, monetary expansion has been going on for many years now, and it has not affected inflation by much. In Japan where QE and other central banking tricks were invented, the problem has almost always been deflation, not inflation.
What all this means is yes, we might get persistent inflation, and many inflation components might not be transitory (wadges for example), but at the end of the day prices for commodities are supply side driven and not driven by monetary policy.
So, if one wants to play in the commodity space, analyzing supply and demand metrics for each commodity separately is warranted. Speculation also plays a role, but speculation almost always drives prices short term and not long term. Lumber is a recent example.
The bottom line is that commodities are affected very little, if at all, from central bank policies. At the end of the day, it is supply and demand metrics that shape pricing.
Insofar as financial assets, yes, they are affected by monetary policy. However please note that in this case it is the intent of central bank to try to affect financial assets. This because this category of assets has a direct impact on financial conditions and the economy.
COVID, inflation, deflation, global growth prospects, interest rates and a bunch of other things that I could probably write a book about, all worry me. However, all the above aside, the thing that mostly worries me above all others is the value of the dollar.
Taking a cue from Star Wars, the dollar is something like the force. When there is balance in the force, things work ok, and the galaxy is peaceful. But when there is a disturbance in the force, then all hell breaks loose.
Similarly, when the dollar’s value is balanced, the global economy is growing, and things are moving alone ok. But when the dollar becomes strong, then things don’t work so well. A strong dollar means there are fewer dollars available for the global economy to function properly. It also means companies and countries that have dollar denominated debts must pay more. But it might also mean a headwind for US companies that rely for a big portion of their profitability from global markets.
A higher dollar might also mean market participants are buying dollars as a safe haven trade. And every time this happens, it does not fare well for equities.
So, if we look at the chart above, one can probably say that as long as the EURUSD pair remains above 1.17, risk assets should continue to do well. But if the pair falls and remains below 1.17, then chances are we might see correction.
On the other hand, if we see the pair above 1.22, then chances are risk assets will continue to perform well, and we might see a strong upward move in equities.
The bottom line is that there are countless things that worry me, and countless things that can cause a correction in the equity space. However insofar as the dollar, if it remains at current levels, it will be one less thing to worry about. And if we see the EURUSD pair above 1.22, then we can say with a little more confidence that the Force will continue to be with risk assets.
With US 10-year bond yields around 1.25% (as of Thursday July 22) the question is, what is the bond market telling us?
Some say the bond market is pointing to stagflation from 2022 and beyond. Others say yields will rise because of inflation, and that these low yields are “transitory”. Other say the low yields point to the continuation of the pandemic with the Delta variant.
Then there are others who think at the bond market is not telling us anything anymore. The low yields we are seeing, despite inflation, are probably a reaction to the liquidity created by central banks. Let us not forget at the Fed the ECB and the Bank of Japan are all continuing to create liquidity at a record pace. So maybe the bond market it is not telling us anything anymore because it can’t.
So where does this leave equities? The answer is by themselves. Stocks do not have bonds to give them a hint of what might happen in the future. And while analysts, economists, and pundits alike are all confused about what the bond market is saying, it’s probably safe to say we should not look to bonds for any kind of direction.
The bottom line is that market participants are very confused as to what the bond market is saying. This confusion stems from the fact at the bond market is giving us conflicting signals based on what we have been conditioned to think for many years now. Maybe low bond yields are a bad omen for global growth, or perhaps not. One thing is true, this is not your grandfather’s bond market.
Up to about 50 years ago, inflation was the main worry of central banks, primarily because high inflation eroded consumer purchasing power.
Today however this has changed, and the main objective is economic sustainability. By this I mean Central Banks want a continuation of growth with or without inflation. Besides, why increase interest rates and crash the economy making a mess of things, only to lower interest rates to try to inflate the economy, and then do the entire thing all over again?
Many say these asset purchases will cause inflation. Yes, it might happen in the future, but over the past 30 years or so, the lessons to be learned are that we are not in the 50s – 70s anymore.
Which brings us to the discussion on when the Fed will lower or even eliminate the 120 billion dollars in bonds it purchases each month.
My guess is that the Fed will continue these purchases for longer than we imagine. The reason is, the last thing the Fed wants are higher interest rates. Higher rates will affect negatively both the labor market and asset prices. Both stocks and real estate prices are likely to trend lower, which will have an impact on the wealth effect, which will eventually impact the real economy.
Also, contrary to many years ago, the US government today has a much higher debt load. Higher interest rates mean more dollars to service this debt. And with fiscal spending still running, the last thing the US Treasury needs are higher outlays for servicing its debt.
So, while you will not hear the Fed saying it, higher interest rates are not what it wants, even if inflation persists. Insofar as what risk assets will do, we do not know. While logic dictates the liquidity created should continue to be supportive for markets, practically speaking the outcome is not a given.