Timid Actions, Fearful Times
Sentinel Investments
By Christian Thwaites
June 25, 2012
Since 2010, investors have traveled between optimism and pessimism every three months. It's negative right now. Here's why:
FOMC: What was that exactly?
A very timid move by the Fed. What was glaring was the entire
board revised down their expectations on the economy: i) GDP down by
$500bn ii) unemployment up 500,000 and iii) lower
core and PCE inflation. Not just for 2012 but next year as well. That takes
complacency to a new level. In April they said that
the economy still had plenty of slack and that inflationary pressures
were minimal. And so they were. So why only a modest extension of
Operation Twist?
- Partly because of pressure...there's a hawkish camp that systematically overstates inflation and finds dealing with the whole unemployment thing very tiresome.
- They want to set the bar high for any further moves. A liquidity crisis, fiscal tightening or a confidence blow would all fit the bill.
- Credit flow is on a slow repair with bank loans up 6% in the last three months so pushing rates lower will probably not help much, which is another way of saying...
- The market is already at low rates; further purchases may distort more than help.
- Allows the Fed to keep talking more aggressively which helps keep the markets primed for some action...so no sell off in bonds expected.
The one thing we like about it is the $270bn of treasury purchases from now until year-end. That runs down the Fed's holdings of 3-year paper to zero as they focus buying in the 6-10 year space, which is typically the benchmark for corporate bond issuance and 30-year mortgages.
Just to keep us on our toes: a non-voting member of the Fed, James Bullard of the St. Louis Fed, went on record that there would have to be a "very high hurdle" for any more QE and that having end dates on the programs is causing frustration. Two responses:
- There's a lot of regional disparity in unemployment and this is what it
looks like from the Gateway to the West...about 2 points lower than the
national level.
Source: Federal Reserve Bank of St. Louis, Economic Research
In our experience, regional Fed chairs know their own districts well, and perhaps less about what's going on nationally. A good agricultural season and manufacturing base have been good for this part of the country. But, unfortunately, they're not symptomatic of the US. - Putting dates on QE programs has been part of the problem. The market simply does not know what the Fed wants out of these programs. They don't set an unemployment target and is the 2% inflation number a target or ceiling? Who knows. If they could only move to a form where actions could remain until a goal is achieved, we would have far less ambiguity. They should try it.
Where are we going with US Economic Data?
Nearly all data shows how rapidly we have lost momentum since
the promising start to the year. Manufacturing, jobs and confidence
have all rolled over, not disastrously but
enough to question whether the early data was i) a back-and-fill from Q4
or ii) weather-related or iii) due to higher energy prices, remember
oil never closed below $100 in Q1,
or iv) reaction to what was then better news in Europe.
Probably all of the above. Thus most of what we have seen in the last two months is a steady drip of confidence impairments. The trouble with these is they can accelerate and start their own downward momentum. And that's what we'll be watching closely. Meanwhile, four brighter spots:
- No inflation: anywhere. The CPI bounce in Q1 was all energy related and reflected a price shift, not an inflationary trend. Retail sales are soft and hiring slow. There's NO wage push or demand pull. The only inflationary indicator is the money base argument. But given the depressed multiplier levels, you would have to have unparalleled faith in monetary dogma to believe that feeds into the real economy.
- Small Business: The NFIB survey from two weeks ago saw employment intentions on the rise and they're the ones pushing the upward trend in C&I loans. They're up about 13% YOY. Yes, it's a fragile sector but essential for employment growth.
- Housing: No not a big resurgence but it started with public company homebuilders running very strong in Q1 (LEN, TOL, HD) [1] and have held up. Then we had NAHB which had sales at a 5-year high and, best of all, the housing starts where every data point this year was revised up, along with the "5-Units or More" stat, which we think crucial.
- Gas: Wholesale gas prices have fallen 4% which should put some
more free cash flow into consumers' pockets. That could help jobs as
well because federal, state and local employment
continues to decline. Here it is from 2009:
Source: Federal Reserve Bank of St. Louis, Economic Research
Europe: Met in Cabo and now what?
Will dominate the news for a while. If this were Grandmaster chess,
they'd be four pieces down and at stalemate. All the major economic
stats are flashing red. Those with structural
reform plans, of which UK and Italy are the most important, are already
seeing severe downturns. As we said last week, Europe lacks a hegemon: ECB: no mandate. Germany: too punitive. IMF: not funded. US: unwilling. EU: unable. And each a veto.
Back in May, the Governor of the Bank of Italy put it well:
Which is, of course, correct. If there were political union, Greece would be like Texas in the 1980s...a trashed banking system and federal rescue...and Ireland and Spain would be like Florida, receiving transfer payments in the wake of a housing frenzy. So, transfer payments and rebalancing could get on with their work.
But there isn't a political union so we hang on shorter term problems like can Spain get its target funding in place (yes, so bonds drop below 7%), are the stress tests going to be good for a week or two (perhaps), will Greece form a government, will there be a new LTRO to balance out the Target 2 imbalances in reserves? All serious problems and we will see twists and turns in capital markets. But nothing to repair fragile sentiment.
The markets are down 6% to 7% but there's nothing obvious to buy. Even the Bunds trade is coming unglued with a near 5% correction in June. This makes sense. They are not a safety trade. Most of the fallout in Europe will land at the door of the German economy and CDS have already risen 20% in a month.
Bonds: The defensive trade
We're at the top of recent trading ranges. We're fading our
treasuries because the trade has been so volatile. The duration on the
treasuries are 9.2 for GT10 and 21.2
for GT30. They trade with fast moves on thin news. Last week we saw the
benchmark GT30 move on the back of a $5bn trade. In a market with $500bn
of daily turnover, that's a nervous market.
The bank downgrades were well telegraphed. Many of the European large money center banks are de facto sovereigns and on life support from the ECB. That explains why the short-term debt ratings were mostly left unchanged. One area that is worth looking at is the US money market mutual fund (MMMF) industry. These tend to rely on commercial paper for much of their assets and banks are big issuers at nearly 50% of all outstanding paper.
Source: Federal Reserve Bank of St. Louis, Economic Research
Non-financial commercial paper has shrunk to less than 20% of the market. In other words, MMMFs rely heavily on bank debt, strive to maintain a $1.00 NAV but have no dedicated capital to support downgrades or impairments. That's why the Fed keeps pressing for reform.
Elsewhere, new issues remain very well bid as does CMBS mostly because of resolutions on multi-family and large properties (there's that property market theme again). The appetite in new IG names are very healthy especially as the treasury market remains well bid and a defensive trade. But don't get sucked in by the yield only story.
Long-term only please: Equities
The S&P[2] is doing better than it did in 2010 and 2011 when we
also saw Q2 weakness: +8.9% vs. unchanged back then. The market has
recently honed in on defensive sectors like telecoms,
services and utilities. In a flight to yield market, they worked. The
core story is the S&P yielding 2.1%, with major pockets of large
caps land trading on 13x with increasing pay
outs. We've seen much more stability in large cap than mid and small
this year: mid cap is +7.3% and small cap 5.9%. The US remains one of
the strongest equity markets YTD.
Also, the day of any FOMC meeting sees the market up 70% of the time and the day after it's down 70% of the time. So no surprises there. We were due for pull back. Expect to be in a range 1250 to 1350 for the S&P, so 75 pts lower than Q1. We'll stay there for a while. So need to pick up good names we want to own on weak days and stay with quality. Trim them at the top of the ranges.
Bottom Line: We're happy to hold 2.5% yielders and 12x. Sure, plenty people have spoken about it but none are doing it! Money is more on the sidelines than headed in. Remember these stocks were the laggards over three years.
[1] To see Sentinel Investments' Top 10 Holdings for all funds, please click here.
[2] Standard & Poor's 500 Index is an unmanaged index of 500
widely held US equity securities chosen for market size, liquidity, and
industry group representation.
Sources: High Frequency Economics, Federal Reserve Board, Federal Reserve Bank of St. Louis, Bloomberg, Tim Duy's Fed Watch, National Federation of Independent Business, US Census Bureau, US Dept of Housing & Urban Development, Bureau of Labor Statistics, CLSA, Banca D'Italia, Sentinel Asset Management, Inc.
(c) Sentinel Investments
